Defi Option Vaults (DOVs) are a new form of structured Product, which utilize the advantages public blockchains provide to improve settlement and clearing, as well as making complex derivatives easier accessible for the everyday pleb.
In essence, DOVs work similar to traditional structured products, where a specific combination of derivatives are selected, packaged and sold to clients looking for custom non-traditional payout curves. Clients are strictly institutional / “accredited” investors and Banks function as Service Providers, charging a fee for their services. This leads to increased counterparty risk, since bank solvency can't be taken for granted (a la 2008), but also high capital efficiency since the Bank can net your positions, leading to lower margin requirements. In TradFi these structured product flows span trillions globally and dominate movements in both the underlying assets and the respective IV's.
In Defi, DOVs try to disrupt this model by utilizing smart contracts as service providers, which are accessible to everybody with an internet connection regardless of their accreditation. This disrupts the traditional model and opens the usage of structured products to a broader audience.
OK, but how does it actually work?
I'll be using ribbon.finance as an example for a simplified technical explanation.
Ribbon offers 2 basic types of strategies: Selling Covered-Calls and Selling Puts in order to earn yield on 8 different Crypto Assets.
Both of these are fairly basic options strategies. When selling covered calls, you are selling additional upside on an underlying asset (which you are also holding) by selling calls to harvest the options premium. This leads to an instant harvest of premium, but can cost you if the price of the underlying rises above the strike price, in which case you would lose out on potential profits achieved by simply holding the underlying. This can cause you to lose out on value if denominated in the underlying (e.g., BTC or ETH) but can never cause losses denominated in USD. Investors sell calls if they anticipate the Market to be choppy / bearish, basically anticipating the Market Price to stay below the Strike Price of the call (otherwise they would have done better just holding the underlying).
Selling Puts is even simpler since it doesn't include holding the underlying, but simply selling naked puts. This means if you expect an Asset to go up, you can sell downside protection via selling put options to harvest the options premium instantly. This however is more risky since it can lead to unlimited losses denominated in USD if the price of the Asset drops below the Put's strike price. (Limited reward: harvesting options premium; unlimited downside: if underlying drops unpredictable)
Ribbon simplifies these strategies via the use of vaults, where users simply have to deposit the funds into a smart contract. The user funds are pooled and invested into the respective strategies at a fixed time once a week. (Friday, 9 am to 11:30 am UTC)
To perform the sale of Options on chain ribbon relies on Opyn oTokens (https://www.opyn.co/) which are ERC20 token representing a typical American options contract with a strike price and expiry date. The vault locks user collateral into Opyn (where it stays locked until the Option expires; since this collateral is needed to pay out Buyers of these Options if they were to expire in the Money) and mints the Options. However, since ribbon want to be short (selling) calls and short puts, they need to find a counterpart to sell the minted Options to.
This works via the use of Gnosis Batch Auctions where bidders compete for the right of being a Buyer of these newly minted Calls (10 minutes auction duration) and ribbon turn into seller now being short these call strikes. Ribbon also sets a minimum price for the Options. The Auction converges at the final price, which is the settlement price for all bidders, even if their bids were higher than the Final Price. (Bids priced in WETH).
The majority of flow is often won by Options Market Making firms like QCP Capital, which can provide the most competitive and tight pricing for these options and then hedge their gained exposure on Derribit (which is easy for stETH, ETH and WBTC since they have liquid Options Markets and harder for other Alts without) or net it out via existing exposure in their Options book to just profit of the spread. The Settlement of sold Options is conducted on chain as well via airswap (https://www.airswap.io/#/)
Expiry and Strike Price Selection:
Ribbon uses weekly calls for all strategies, which always expire Fridays at 8:00 am UTC, followed by the auctions for the next weekly calls from 10:20 am to 11:30 am. This time is chosen to coincide with the weekly options expiry on Deribit, since this makes hedging of won Call flow easier for Market Makers. With ribbon v2, the strike selection is now done algorithmically on chain. The strike selection process however is fairly basic: Spot Prices for the underlying are pulled via Chainlink oracle and ribbon team manually inputs values for Deribit DVOL index, which is a measure of the options implied Volatility. Then the closest strike with a Delta of 0.1 is selected. Delta 0.1 means the closest Strike, which is priced with a 10% probability of the Option expiring ITM.
The Risks of selling Volatility:
The Marketing of many Defi Option Vaults like ribbon often evolves around the Idea of “sustainable” yields.
I believe this kind of marketing is pretty misleading. Selling Options to harvest the Premium doesn't inherently generate any yield or Alpha (excess returns above the market). The Option's Premium can simply be viewed as the Market's risk premium of the Option expiring in the Money and causing Holders losses denominated in the underlying.
Selling Volatility should be used like any other trading strategy: when you have evidence that Volatility is overpriced by the Option's implied pricing compared to what you believe, the actual Odds of the underlying reaching the strike price. Don't think that recurring selling weekly options in a vault like manner without any empirical evidence of said options being priced wrongly by the Market is the correct way to approach options trading. Just like, I wouldn't recommend anyone indiscriminately buying calls or puts without any thesis / evidence of them being underpriced. Otherwise, you can make yourself vulnerable to the one unexpected market event which wipes out months of short volatility gains “or yield”: The one hypothetical week in which Ethereum rallies 30% and wipes out Months of ETH denominated short vol gains or even causes heavy losses denominated in ETH.
In general my thoughts can be summarized best as I do believe that DOVs provide important and interesting infrastructure, which however is used in an unfavourable manner by most participants. This is reinforced by Marketing which equates selling calls with some kind of risk-free rate or Alpha, since a DOV customer that keeps his assets locked in the vaults 365d a year obviously generates more revenue for the protocol compared to a customer that understands the risk of selling calls and only enters the DOV vaults strategically to express his Market view as a Trade. (Ribbon takes 2/20 management / performance fee, similar to most traditional hedge funds and definitely very rich compared to the simplicity of strategy they are providing)
TLDR; I don't believe that shorting volatility is necessarily a bad idea, it's just that shorting volatility at a fixed time, weekly at any price and for 365d a year in a vault like manner is likely a bad idea. Selling volatility shouldn't be something that's done systematic without any concerns for current market conditions.
While this might not be applicable to most DOV User, there is probably a minority familiar with the tradeoffs and willing to sacrifice some upside on the underlying for consistent payoff. This could be applicable to many protocols token treasuries, who through the use of DOVs could for the first time get access to Volatility Markets for their Altcoin. Ribbon recently added vaults for: AAVE, AVAX and SOL and is probably looking to expand their offering further in the Altcoin Space. This is interesting since none of these token currently have liquid Options Markets on a Centralized Exchange, but rather Defi is leading the innovation in this area.
I also believe the instant settlement via the use of public immutable blockchains and the removal of centralized clearing houses is generally a very good thing, especially in times when exchanges like LME (London Metal Exchange) have set the precedent of reversing unfavorable trades if they feel like it.
DOVs play a key part in enabling this on chain trading of options by socializing gas costs among thousands of user via the vault model, where instead of thousands of user individually making on chain trades and paying for gas, the vault makes the options transactions for the entire vault.
Thanks for reading!
