Evolution of DeFi Option Vaults
The DeFi Option Vault (DOV) is a vault that accepts a specified asset and deploys the asset in an option trading strategy. These strategies usually sell options to earn risk premiums. A DOV can often create a sustainable yield for around 10%-40% for ETH, BTC, and USDC. Likewise, the investor or staker will bear the risk of losing money if certain options within the strategy hits the strike price. Currently, about $700 million is locked in DOVs according to QCP’s article, which also includes a detailed explanation of DOVs. In this article I will delve deeper into the technologies and mechanisms of DOVs.
DeFi Option Vault V1
Vault for Deposit and Earn
Ribbon Finance (Ribbon) was the first company to incorporate DOVs. By creating ETH, BTC, and USDC DOV vaults, investors deposit assets into these vaults and start earning yield from options trading. There is no Impermanent Loss but there are withdrawal fees and the natural risk of hitting some strategies strike price and losing out on principal.
Covered Call and Put Selling Strategy
Option strategies that DOVs employ are often covered call or put selling Strategies, which are also common in traditional option trading on stock markets. The strategy involves using the fund as collateral to mint OTM put or call options then sell the option to earn premiums. The strike price, and thus risk profile, of each specific option is decided by a manager off-chain.
OTC Trading
The trade is executed through on-chain OTC platforms such as Airswap. The deal is decided off-chain; inputs such as the amount of option tokens and the premium in a transaction is signed by the two parties. The whole transaction is then broadcasted and the result is publicly auditable on the blockchain.
DeFi Option Vault V2
There are many newcomers in the sphere of DeFi Option Vaults, bringing new innovations.
Trade through Auction
Ribbon V2 uses Gnosis Auction to sell options. It allows price discovery on-chain and allows the selling process to be decentralized. However, the premium yield is generally lower than Ribbon V1.
On-chain Strike Price Selection
In Ribbon V2, rather than off-chain, the strike price can be auto-selected by a smart contract using predefined Delta. The whole process is thus decentralized with the performance of the strategy more transparent and predictable by investors.
Collateral for Extra Yield
The collateral can be a yield-bearing token so it can create extra yield. For example, Ribbon allows stETH and yUSDC to be collateral and StakeDAO allows staking collaterals in their passive strategy.
In Protocol Settlement
In Ribbon V1, options need to be minted and settled through Opyn protocol. New DOVs like Thetanuts can hold the collateral and settle the option in their protocol. Ribbon V2 on Avalanche also doesn’t need to rely on the full Opyn protocol but only uses their Margin Pool to hold the collateral.
Cross Chains Deployment
There are many DOV deployed on different chains - Thetanuts is deployed on 5 blockchains, Katana and Friktion deployed on Solana, and Ribbon also deployed on Avalanche.
More Diverse Assets
Not only ETH, BTC, and USDC are put into DOVs. DeFi Tokens such as AAVE and other Layer 1 tokens like AVAX, SOL, and FTM can also be put in DOV. More option contracts can be made with these assets, massively increasing the liquidity of their option markets.
Providing Liquidity for DeFi Options
Projects like Premia and Lyra also provide vault products but asset stakers aren’t selling options to certain counterparties but rather provide liquidity to option markets. This means that an investor will be indirectly selling varied options with different strike prices and expiry dates to retail investors. This idea is not exactly like the DOV but it’s nonetheless worth mentioning.
What DeFi Option Vault V3 will be?
DOV is still an early technology and I believe that there are many avenues for improvement in future DOVs.
More Advanced Strategies
Currently, covered call and put selling strategies are very effective and in the foreseeable future. However, when large players begin to enter this space, such as Goldman Sachs entering into the crypto derivative market. More advanced trading strategies should be implemented in DOVs to maintain the same level of sustainable yield.
Improved Option Trading Mechanism
Strike price selection and price discovery are the key parts of maximizing premium profits. There remains room to improve the mechanisms of DOVs to be more efficient, transparent, and accessible for retail traders and other market participants.
Increate Capital Efficiency
Most DOVs require 100% collateral to mint option. In the contrast, Traders on CeFi option exchange Deribit are normally using 10x leverage. Obviously, we will need partial collateral to increase capital efficiency and a well-design liquidation mechanism to protect the system.
Lower Threshold to Create DOV
There is a demand amongst people, companies or treasuries with a large number of assets or tokens to enter crypto option trading and earn sustainable yield. DOV creation processes can be more transparent and streamlined to allow more interested entities to easily create a DOV and start earning.
Conclusion
I believe there’re more innovations that can be done in this field. I look forward to the potential and bright future of DOVs.