April 21, 2022
Ribbon Explained by Variant Research
Variant Research is boutique crypto research team made up of DeFi analysts and option traders who consult for various funds, projects, and family offices. More recently they started their own content wing in order to distill and disseminate the more complex ideas within crypto markets.
You all know I am a fan of the Option Vaults, like anything they have flaws, but in the future these will be invaluable to the crypto native tool-kit. In time, they will take the inflationary and unsustainable APY’s we’ve all become accustomed to in defi and replace them with sustainable (albeit lower) APY’s. This coup of current norms is imperative to the growth and legitimacy of our industry. In the long run it’s a net positive, and the best way, actually the only way to do this (in my mind) is by using Options.
Which brings me to Ribbon, I am sure most of you have heard of Ribbon by now. They have built a series of structured product vaults which I have talked about ad nauseum.
"Ribbon uses financial engineering to create structured products that deliver sustainable yield. Ribbon's first product focuses on yield through automated options strategies. The protocol also allows developers to create arbitrary structured products through combining various DeFi derivatives.”
Out of all the structured products protocols, Ribbon is the biggest by TVL (TVL is akin to assets under management). After a quick search on DeFi llama it appears Ribbon now boasts a staggering $244 million dollars locked up between its various vaults, the lion’s share being traded on the Ethereum chain of course.
As you can see below from the performance of the RBN token, I am not the only believer in the protocol. The market is increasingly coming around to the view that Ribbon (or similar) is the only sustainable form of yield enhancement in defi.
What does Ribbon do?
The elevator pitch goes something like this, Ribbon executes options strategies for its clients and distributes the earnings proportionally. Clients deposit money in Ribbon’s vaults and generally the vault sells an option for the client where the premium received becomes the yield enhancement.
Let’s say Ribbon has a Covered Call Vault which has $9 dollars in it.
👉 You deposit $1, you now own 1/10th of the pool.
👉 Ribbon uses the $10 to sell a covered call.
👉 The premiums are distributed to the vault.
👉 The options expire worthless at the end of the week and you can collect your original collateral plus 1/10th of the premium.
If that’s all you take away from this article I won’t be offended, but personally, I like the feeling of falling down rabbit holes, so let’s crack on. As mentioned, Ribbon is using Option strategies, but how are the options purchased and sold? Let’s look at the workflow and rationale on a more granular level.
Step 1: User deposits funds into a vault (let's say as an example, its ETH funds)
Step 2: Ribbon sells ETH Calls on Opyn. The strike is out-of-the-money and the notional is the same as the funds in the vault.
Step 3: Opyn mints a token representing the Call (so owning the token means you own the Call option)
Step 4: Most importantly Opyn’s smart contract makes sure the vault's funds are fully collateralising this call option, so the owner of the token never has to worry that the vault doesn't have enough money to pay out if the option ends up in-the-money.
Step 3: A bidding process takes place on gnosis or telegram (soon to be replaced by Paradigm) where Ribbon sells these tokens to market-makers
Step 4: One of the market makers wins the auction and their ETH address is whitelisted to purchase the tokens, which means that market maker owns call options
Step 5: The premium is deposited in the vault. If the option expires OTM vault depositors will have made a small amount of interest for the week.
Why do users put money in Ribbon?
High APY - current 17%pa on the above ETH vault! But more importantly you are selling a call on the asset you own - so you are giving up upside only. That's pretty easy to stomach for most crypto investors - assuming they are compensated well.
Why do market makers buy these options from Ribbon?
Market makers are generally volatility traders - they buy these options and then delta hedge to express a view on the relative value of that ‘volatility’. Ultimately they don’t really care if it goes up or down as long as it does so in a volatile fashion. I have plenty of resources on this - if you don't understand what i am talking about, check out this thread:
Plus they buy it with no credit risk / exchange risk since it's all done via a smart contract!
Now that our very brief overview of what is otherwise a complicated topic is complete, let's look at one of the problems plaguing most of these structured products. A key area of friction is that most vaults are selling weeklies (meaning the options expire every Friday,) which means the vaults need to settle their positions every week and start anew. To put it plainly, every Friday these products need to sell a whole new batch of options to market makers. As you can imagine this can be quite cumbersome. Especially if you are trying to sell this stuff over telegram, which is how it's done currently.
Let me preface with what I am about to say. I am a big fan of ship, then iterate, but in an industry full of certified giga-brains it’s only a matter of time before a better system comes along. As it turns out we are at the genesis of such a system. I found out during my interview with Paradigms CEO Anand that they were in fact positioning themselves to be the key facilitator of this flow.
If you don’t know about Paradigm - see my attached interview with Anand, but Paradigm is broadly speaking where anyone who wants to do large size crypto derivs goes in order to get size done at a good price.
Anand explained the solution during our interview. Here is what he had to say.
"We are in the process of integrating with these vaults and we are partners with the larger ones like Ribbon, Thetanuts and StakeDao, as well as a number of non-vault option exchanges like Opyn and Zeta Markets. The way we see our role in this space is similar to where we saw ourselves in CeFi, we will connect the vaults with our large liquidity network to run a fair auction which is ultimately better for vault investors. Most importantly this would be through our existing interface - so a bidder basically sees a similar workflow to deal options for cefi exchanges and defi protocols all in one place! So DOVs operators don't have to waste their Fridays trying to coordinate hundreds of prices via chats (by the way I have talked to everyone - Friday nights are gone for the entire defi options community both for the protocols and the bidders."
”Option-selling strategies such as covered calls make the most sense in a lower yielding environment. The base yield now in crypto is very low vs. the average of 2021 yields, and perhaps more importantly vs. retail investors’ expectation of crypto yields. Nobody in a real world bank account expects to get 15-20%pa on their cash, but in crypto they do - and given that generally you can no longer get those sort of base yields anywhere outside very select protocols where the risks have been well-flagged, option vaults are one of the few avenues left for investors."
The @tradeparadigm team gave me a sneak peek of how the Ribbon auctions will look once live on Paradigm 🔥... for those of you who are already on Paradigm, this should be very familiar - just a click of a button to switch from Cefi to Defi!
To bridge the schism between crypto native and everyday Joe we need to get inventive.. These types of partnerships between Ribbon and Paradigm only serve to make the industry overall more efficient, which in turn gives the user a better experience. Pleasant experiences lead to adoption, at the end of the day that should be everyone's goal.
A rising tide lifts all ships, or something like that.