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A Deep Dive Into Pooled Liquidity in DeFi Options: FinNexus

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Published on:
February 18, 2021

FinNexus takes a deep dive into the ways that DeFi options uses pooled liquidity as a solution.

A Deep Dive Into Pooled Liquidity in DeFi Options: FinNexus

Table of Contents

DeFi options are still at an experimental stage. Here in this article, we will mostly discuss possible solutions to manage liquidity for DeFi options in a pooled system. This does not necessarily mean that a pooled-liquidity solution will be better than relying on order books or that it is the only solution. Indeed, we must continue to monitor the development of liquidity solutions in all DeFi options projects.

As 2021 approaches, crypto derivatives are no doubt one of the hot topics in DeFi.

Following the launch of centralized derivative platforms like Deribit and Bakkt in 2019, options took the crypto derivatives market by storm in 2020, with volumes crossing $1 billion for the first time in December, according to Cointelegraph, marking the end of a parabolic year for the growing market niche.

Though centralized exchanges still control most of the market share, decentralized options platforms have begun operating in 2020 and are growing rapidly.

Here is a bit of a recap on pooled liquidity solutions in DeFi.

Liquidity Pools in DeFi

As introduced in this article, liquidity pools have turned out to be successful solutions to provide liquidity in DeFi. There are different kinds of pools elaborately programmed for liquidity under various scenarios, and their applications are ever-growing. Lending pools, market-making pools and options collateral pools are among the best known.

image altdecenpools

Essential Elements of Pooled Liquidity in DeFi

  • Collective liquidity or monetary pools are not indigenous to DeFi — they have long existed in legacy finance. However, in traditional finance, these pools often entail under-the-table operations which are all but transparent.
  • On the contrary, built on blockchain technology and with an open-coded nature, on-chain liquidity pools in DeFi are fully traceable and transparent, something that greatly lowers the centralized counter-party and settlement risks.
  • The current on-chain Ethereum system is not suitable for high-frequency orderbook transactions and settlements, with operations being both expensive and affected by low efficiency. Pools coded using different algorithms and various financial models can be more cost-efficient and effective ways to boost liquidity, working in an automatic and fair manner.
  • The ability of pools to collect scattered peer-to-peer liquidity automatically is extremely useful when new projects start out. DeFi is still small compared with traditional finance, though developing at an amazing speed. Pooled liquidity is a perfect solution when building new financial models on-chain with limited participants both in quantity and volume. Like in decentralized exchanges with AMM pools, with the peer-to-pool model, users trade against the collective pool, with much deeper liquidity and lower slippage.
  • Pool contributors can earn transaction fees and other incentives in a passive and automatic way. It is friendly both to new traders and yield hunters.

Traditional Options Tradings

As introduced here, an option is a binding contract that allows one party — the buyer — to sell or buy an underlying asset at a predetermined price within a set time frame. An options contract presents several essential elements including its underlying asset(s), type (a call or put), strike price and expiry date. Any change to these terms would turn it into a new contract.

Options contracts are derivative financial instruments open for trade. CME Group is one of the best-known options exchanges focused on traditional financial products, like bonds, crude oil, fiat currencies, etc.

Even when Bitcoin and Ethereum are their underlying assets, crypto options are still mostly traded in a traditional manner in centralized derivatives exchanges. The most popular is Deribit, which currently holds over 80% of the total market volume.

deribit

The image above refers to Deribit, where options are traded in a similar way to traditional finance. As one may notice, it looks very different from spot trading and might be overwhelming to less sophisticated users.

Order book liquidity is maintained for each of the options contract and controls the depth of each trading pair. The bid-ask spreads are diversified for options with different terms and usually, there is less liquidity available the more strike prices deviate from the market price.

How Is DeFi Options Trading different?

DeFi options transactions are quite different from the spot and perpetuals trading in decentralized exchanges.

  1. Spot trading basics are easier to grasp, with limited pairs in both centralized and decentralized exchanges, like the ETH/USDT pair on Binance or Uniswap. By contrast, options contracts are individually bonded with different terms. This means that talking about a type of option will not make much sense if we are not specifying the exact terms attached to the contract. Even for options on a single underlier — let's say ETH paired in USDT — there can be potentially unlimited types of calls and puts with various strikes and expirations. (For a graphic representation, just look at the dazzling interface on Deribit.)
  2. Such a wide variety makes it extremely expensive and capital-intensive to build a liquid market for all trading pairs on chain. The Ethereum network is not suited for building order book liquidity, due to on-chain transaction inefficiency and high gas costs. Plus, if liquidity is segmented among different options, massive occupancy of funds is needed to maintain the market depth.
  3. Options are financial products with an expiration. Past expiry, the contracts will not be enforceable. Unlike spot trading or perpetuals, which may theoretically last forever, options pairs will stop trading after expiration and new pairs need to be created continuously. In DeFi, this means platforms would have to frequently remove liquidity from the expired pairs and regenerate markets on new ones. When options are tokenized for trading on Ethereum, this can be costly and lead to impermanent loss problems if the XYK Automated Market Maker model, as in Uniswap or Sushiswap, is applied.
  4. Options contracts are not balanced in terms of rights and obligations between writers/sellers and holders/buyers. Writers only have obligations and get premiums as compensation. They need to deposit collaterals to make sure of full settlement. This is especially important for options on-chain. Options buyers are not required to collateralize assets but need to pay for premiums. This transaction structure is quite different from spot trading and needs to be specifically taken care of in building liquidity.

The Possible Solution to DeFi Options Liquidity

As introduced here, a handful of DeFi options platforms emerged in 2020. One of the most important ways in which they differ from one another lies in how they solved the problem of liquidity. The table below was updated in Feb 2021.

Order books seem to be one choice. OPYN v2, Auctus, Hedget and Premia are on this path right now. OPYN v2 liquidity is built on the 0x Order Books, while Auctus, Hedget and Premia are building their own exchange platforms. It is interesting to see how they will evolve to enhance liquidity with order books. Opium also experimented with order book liquidity models, but recently it switched to a pooled liquidity insurance model. Also in addition to the orderbook model, recently Auctus launched ‘Private Option Pools’.

Even among liquidity-pool solutions, the details vary. In general, though, projects fall into two types, with the liquidity pools working as the collective collateral for options sellers’ or AMM liquidity for options transactions.

1. Liquidity Pool as Options Sellers’ Collaterals

Hegic and FinNexus are both enhancing liquidity by collecting the sellers’ collaterals into liquidity pools to power options.

Hegic’s Liquidity Solution

Hegic Pool

FinNexus’s Liquidity Solution

FinNexus Pool

Essentials of the Model

  • Liquidity pools are also collateral pools, working as the counter-party to all the options, with any variety of terms, written from that pool.
  • One pool can power different options with various terms simultaneously. Risks are diversified and premiums are shared automatically.
  • Liquidity is collectively shared with all the buyers, and options are traded with little price slippage.
  • Liquidity/collateral pools provide constant liquidity for options transactions. The market for a specific option does not need to be terminated or rebuilt when the contract expires. Liquidity providers do not need to worry about rolling their liquidity to another pool at expiration.
  • This model provides flexibility for option buyers, who can literally tailor their options terms according to the needs.
  • Interfaces can be designed to be simple and easy to operate for new users.
  • Pool participants are collected together in the pool as options writers. Due to this, there may be risks if the market makes dramatic movements that are unfavorable to the options sellers. Please refer to the simulation here for the financial behavior of the collateral pools.
  • The major arguments against the pooled-collateral model are that, on one hand, the pricing relies on external feeds, and on the other hand, it is hard to build secondary markets. Furthermore, writers cannot sell specific options when they want to, which limits the flexibility of options strategies.

Differences Between Hegic and FinNexus Liquidity Solutions

(1) Pool Compositions

  • Hegic has two pools with WBTC and ETH as collaterals. Each pool powers contracts with corresponding underlying assets. Options are purchased and settled in WBTC and ETH.
  • FinNexus has two pools on Ethereum, with USDC/USDT and FNX as collaterals. Options are purchased and settled in the related collateral asset. FinNexus’s pool deploys a MASP (Multi-Asset Single-Pool) mechanism, which allows hybrid assets as collaterals, like in the USDC/USDT stable coin pool. The choice for payments is more flexible. The FinNexus team is planning to add more types of assets as collateral in the future.

(2) Underlying Assets for Options

  • Hegic options’ underlying assets are currently WBTC and ETH. Both WBTC and ETH calls and puts have deep liquidity.
  • At present, FinNexus supports five crypto assets as underliers, although the MASP mechanism allows for potentially unlimited types of assets to be added, including commodities, stocks, fiats, indexes, etc. Settlement takes place in stablecoins and in this regard, the system is more in line with trading conventions.

(3) Pool Risks

  • With Hegic, because WBTC and ETH pools are separated to power the corresponding options, risks are somehow more concentrated and more likely to be hedged for liquidity providers. An auto hedging mechanism is under construction.
  • On FinNexus, with more diversified underlying assets, together with a risk adjustment parameter for options pricing, liquidity providers’ risks are more diversified. The platform is designed to automatically dilute risks with its universal pooled-liquidity mechanism. Moreover, FinNexus introduced a risk-adjustment parameter, to act as an AMM mechanism and better balance the distribution of puts and calls in the pool.

2. AMM Liquidity for Options Transactions

AMM (automated market makers) are one of the greatest creations in the DeFi space and has also been experimented with options transactions.

OPYN, Primitive, Charm and Siren are all platforms relying on AMM solutions to trade options, each bearing unique characteristics.

OPYN

OPYN offers tokenized options in ERC20. OPYN v1 has American, physically settled options and its liquidity is built on Uniswap. OPYN v2 offers European, cash-settled options and its liquidity uses 0x Exchange with 0x Order Book. (Please notice that we will not cover the order book liquidity in this article.)

With tokenized options, OPYN v1 facilitates options transactions with Uniswap-based AMM liquidity. Specific pairs are maintained with different liquidity pools, mostly operated and powered by OPYN. As some options come to expiry and new options are created, old pairs are terminated and new pairs initiated.

The advantage of Uniswap-based liquidity is that they are permissionless and easy to create. Users can be easily buying and selling options with Uniswap interfaces. They can also build different combinations of strategies easily.

However, liquidity providers are likely to suffer from Impermanent Loss due to the time decay of options. That’s why it is hard to attract outside participants in the liquidity pools. It is also costly and capital-intensive to simultaneously maintain, terminate and create new options trading pairs.

OPYN v2 went live early in 2021 with new features covering capital efficiency, flash mint and liquidity.

Primitive

Primitive options are tokenized like OPYN. Interestingly, short positions are also tokenized as the short option tokens. Short option tokens are useful because they have a bounded value. They are at least worth the strike tokens if the long options were exercised.

Uniswap AMM is used for providing liquidity, but unlike OPYN, liquidity providers supply short option tokens and underlying tokens to Uniswap pairs. When users buying options, the Uniswap V2 Flash swaps is used, depositing underlying tokens and selling their short option tokens back in one transaction. Therefore, the trader does a series of backward transactions to buy options.

Advantages include that impermanent pool risks are greatly mitigated by creating short option token pairs, these have negative time decay.

However, building liquidity for every options trading pair using this system is still costly and capital-intensive. With multiple flash swap transactions, the gas costs could be higher. And since operations go backwards and the system is highly integrated, risks may be heightened.

Charm

Charm offers tokenized European-style call options, put options and covered call (shorting puts) options. Instead of relying on AMM liquidity on Uniswap or Sushiswap, Charm applies a prediction market mechanism to options, with prediction market AMMs called LS-LMSR, acting as a bonding curve.

The options liquidity is created according to the following structure:

Calls + Covered Calls = Underlying

Puts + Covered Calls = Stable Payoffs

Liquidity providers can supply liquidity for calls and covered calls that add up to the value of underlying assets they deposited, or puts and covered calls that add up to the stablecoin value.

The innovation here is:

  • The price is determined purely by supply and demand with narrow spreads.
  • The LS-LMSR system does not rely on attracting liquidity providers to deposit the assets being traded. It can be thought of as a type of token bonding curve that supplies multiple tokens using a multivariable cost function.
  • The sum of the prices lies between a narrow range, which means an investor who holds these options will suffer a smaller loss under worst-case scenarios. There is less risk to liquidity providers compared to options traded on constant-product markets like Uniswap.
  • Charm Options v0.2 partly solves the liquidity fragmentation problem by allowing a single liquidity pool to power multiple options with different strike prices.

However, it is important to notice that liquidity providers still have counter-party risks and losses may be more than the transaction fees collected. Hedging is needed according to different positions and could be difficult for the majority of participants. Also, liquidity can only be shared among designated options with the same strikes and expiry dates. It can be challenging to boost multiple options simultaneously.

Siren

Siren also tokenizes both the options’ long and short sides into bTokens and wTokens.

The platform applies a custom SirenSwap AMM that uses a combination of a bonding curve and options minting to trade both bTokens and wTokens. With the AMM v2 they will use AMM pools to trade multiple markets that share the same collateral and payment assets.

When a trader buys options from the AMM pool, the collateral in the pool is used to mint a new token pair (a bToken and a wToken). bTokens are sent to the buyer while wTokens stay in the pool. Over time, liquidity providers become covered option writers in a passive way, automatically underwriting options contracts.

This is similar to Hegic and FinNexus, but the options are tokenized and the pools are unidirectional. For instance, for WBTC/USDC calls the collateral asset must be WBTC. Additionally, apart from BS model approximation, Siren uses a bonding curve to determine slippage for each trade, which benefits liquidity providers.

Siren’s model is innovative as it combines the pooled collateral model with an AMM mechanism, by tokenizing long and short options traders. Also, a bonding curve is applied to allow slippages according to the relation between supply-demand.

The concern here is that separate pools need to be managed, as the ‘long’ pools and ‘short’ pools are separately built for options on different underlying assets. Liquidity is still segmented while risks are not diversified enough for pool participants. In the pool, the participants are not just providing liquidity for transactions, but also taking a position for writing puts or calls. They may need to hedge against the risks according to their exposure.

A Possible Way Forward

Due to the unique characteristics of options, it is challenging to bring contracts and transactions on-chain while maintaining adequate liquidity. There are currently a few DeFi platforms trying to tackle these issues using various solutions, most of which have never been used in traditional finance.

Compared with financial derivatives in traditional finance, often measured in quadrillions of dollars, the DeFi options market is still a baby, but with great potential.

Liquidity is the key to solve this puzzle and, ultimately, it is what DeFi projects are hungry for.

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Author(s)

Ryan Tian

I'm the co-founder and CFO of FinNexus.

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