Oct 6, 2022

12 min read

Best Practices for Building Decentralized Option Vaults

Some Suggestions on Building the Crypto Structured Products in Best Possible Way!

Decentralized Options Vaults (DOVs) are structured products offered on-chain, closely related to TradFi counterparts that combine several financial instruments to create a whole new payoff curve. The core function of DOVs is to use investors’ capital and employ options trading strategies in a completely automated and decentralized manner. These strategies may include covered calls, protective puts, or straddles. Before DOVs, option strategies were only available to accredited investors through over-the-counter (OTC) trading or by self-execution on option exchanges like Deribit or FTX.

DOVs allow their investors to earn true return on investment (ROI), not just passive income from liquidity provision. The capital is being actively invested in trading strategies, and is independent of the amount of trading being conducted i.e. there is no token “yield” in the traditional DeFi sense. From scratch, DOVs have grown exponentially to become the dominant part of the ~$1 Billion DeFi option TVL, with notionals trading in billions of dollars every month.

Graph Showing TVL trends for Option Protocols in Crypto — Picture Source: Ledger Prime

Over the past several months, DeFi ecosystems across different blockchains have witnessed a massive surge in new projects focused on structured product vaults with the objective of offering users sustainable yield. Given the infancy of these popular products, we aim to define some very basic suggestions on what a builder must keep in mind while launching DOVs. We aim to critically analyze core functionality behind DOVs, from the trading strategies used to the technology behind the vaults, and how we believe these vaults can be improved.

How do DOVs Work?

As mentioned previously, DOVs allow investors to deposit capital and then automatically trade popular options strategies with it. The most common options strategies employed by DOVs include covered calls and protective puts. Let’s look at these strategies in greater detail.

Through a covered call strategy, when vault sells a call option, it will also own the underlying security for that option. Similarly, through a protective put, when a vault sells a put option it will also sell the underlying security for that option. Let’s explore this in greater detail below.

Selling Covered Call Options vs Selling Put Options:

Let’s first look at the two of the most popular option writing strategies: selling covered calls and selling puts. A covered call is a financial strategy wherein the investor selling a call option owns an equivalent amount of the underlying security. This strategy can be created by holding a long position (spot) on an asset and then selling call options on that same asset to generate an income stream. This strategy entails very low risk as the investor’s ownership of the underlying can serve as a cover if the call option expires in the money and the buyer of the call option chooses to exercise. DOV users have a choice to choose either covered call or covered put strategy. If the user feels bearish, they can opt-in for the covered call position and earn yield as the market goes down. Vice versa for users who feel bullish, they can opt for the covered put option to earn yield. Let’s take a deeper dive into the two:

Selling a Covered Call:

- By selling a call option, you have the obligation to deliver the asset (e.g. ETH) at a predetermined price (strike price) to the option buyer if they exercise the option.

- If the seller of the call option also owns the underlying security (fully collateralized), the option is considered “covered” because they can deliver the instrument without purchasing it on the open market at possibly unfavorable pricing. Writing call options should be the same size as the underlying long position. For example, if you own 1 ETH, you can sell 1 covered call option. Owning the underlying asset is necessary because selling naked call options without owning the underlying asset exposes the options writer to unlimited risk.

- A covered call will limit the trader’s potential upside profit, capping gains above the strike price. For example, if you sell a call option with a strike price of $2,000, you are giving away profit of the underlying asset above $2,000.

- The goal of selling a covered call option is for the option to expire worthless, allowing the trader to earn the option’s premium while keeping 100% of the underlying asset as collateral

- A covered call serves as a short-term hedge on a long stock position and allows investors to earn income via the premium received for writing the option. Covered call selling typically does well during choppy or bearish environments as the spot price is unlikely to breach the call strike.

Graph Showing the Covered Call Strategy for Options — Covered Call Option Strategy. **Source:** **Edelweiss**

- Covered calls should be fully collateralized so that the risk does not come from selling the option as it is covered by the crypto the writer owns.

· If strike price < market price and it is fully collateralized -> writer still makes option premium + gains on holding the crypto.

· If strike price < market price and it is half/not collateralized -> then if crypto assets rocket in price, loss can potentially be unlimited.

Selling a Put Option:

By selling a put option, you have the obligation to buy the asset (e.g. ETH) at a predetermined price (strike price) from the option buyer if they exercise the option
Selling a put is an options strategy used to generate yield (income) when traders believe the underlying asset price is unlikely to fall below the strike price before the expiration date
Note that the writer of a put option will lose money on the trade if the price of the underlying asset drops below the strike price at expiration
The goal of selling a put option is for the option to expire worthless, allowing the trader to earn the option’s premium while keeping 100% of their collateral

Graph showing the pay offs of a Put Option Contract — Source: **Investopedia**

What Should Buidlers Keep In Mind?

Adoption of ERC-4626:

The main problem developers face while building tokenized vaults is the integration of different yield bearing tokens. For example, in a situation where you want to build a DeFi app which requires integrating the tokens of each protocol, you will need to research each one, know their model of accruing yields, and adjust it into your code base. If you want to integrate vDAI of Maker DAO; stETH on Curve; and so on, you will need to understand the peculiarities of their smart contracts and build custom solutions to successfully integrate each of them into your DeFi app.

Apart from how stressful and time-consuming this process of integrating different yield-bearing tokens can be, it also increases smart contract risk because of potential errors. Developers will need to spend more time checking for potential loopholes in the adapters, and in some cases, they might even need to outsource it to smart contract auditors, which can be costly. This is more important now that attackers are breaching the integrity of a lot of protocols and DeFi apps. Hence, the creation of the ERC-4626 standard.

What exactly is ERC-4626? It is a standard API for tokenized yield bearing vaults that represent shares of a single underlying ERC-20 token. The vault standard introduces the concept of shares as a way of getting fractional ownership out of the entire pool. These shares refer to yield-bearing tokens. When users put any funds into the vault, the deposit function triggers the smart contract to mint a corresponding amount of shares to the depositors. The withdrawal function helps owners burn shares in exchange for assets. The ERC-4626 is a compatible extension of the ERC-20 standard. As a result, most of the usual variables, events, and functions that are applicable in ERC-20 token contracts still work with the ERC-4626 vault standard.

While there are a couple of prominent token standards at the moment, the DeFi world still has a recurring problem regarding tokenized vaults. DeFi aggregators have always found it quite stressful to aggregate several yield-bearing tokens because there was no standard. But now ERC-4626 makes it possible to have details of yield-bearing tokens with one API call.

The standard makes the integration of protocol easier and less prone to errors. Since there is a common standard that you can integrate, there is no actual need to build separate adapters any longer. It quickens development and enhances composability. Similarly, it reduces cost because builders no longer need to get auditors to help with their adapters and interfaces. Most importantly, ERC-4626 enhances security among dApps and yield aggregators that are dealing with yield-bearing tokens.

Who uses this standard? Protocols such as Balancer Linear pools, Yearn finance, Yield protocol, Alchemix v2, Convex finance yield pools, and more are already using this protocol actively. The problem of going the extra mile to enhance the security of DeFi applications with yield-bearing tokens is solved — to a large extent — with the introduction of this baseline standard. Use of composability and interoperability among various DeFi protocols will increase in the next couple of years. It is even possible that this standard will be a launchpad for building and shipping completely new products in the DeFi ecosystem.

Can Be in Line With Existing Successful DOV’s Strategies:

The appeal of the DOVs emerges from its seamless accessibility and simplicity for the user. Investors simply ‘stake’ their assets into the vaults which are automatically deployed into option strategies.

The strategies deployed thus far have been selling covered call and put strategies (which we discussed above) providing the highest base yield available in Defi (averagely 15–50%). On top of that, token rewards are distributed, providing an even higher yield for users. In some instances, the collateral in the vault earns staking/governance yields as well, creating three sources of yield in a single vault. This triple layer of option premiums, token rewards, and staking yield creates a significantly high and — more importantly — sustainable yield that is unprecedented in Defi.

Another major problem DeFi must solve is non-linear liquidations. Even centralized exchanges like Deribit manage non-linear liquidations with some difficulty. For the liquidation of large option portfolios, the delta (or spot risk) is managed first by executing a perp/futures position against the portfolio. The other greeks in the portfolio (non-linear risk) are then systematically liquidated over time with an active involvement by the intermediary.

By using a hybrid DeFi model where investment, collateral management, price discovery and settlement occur on-chain while non-linear risk management is performed off-chain, DOVs provide an elegant solution to this problem. All option contracts traded through DOVs are fully collateralized which eliminates the need for liquidations completely.

Refine Options Trading Strategies to Make Them More Dynamic:

All DOVs typically only offer covered calls or protective puts and they will trade on these options strategies on a weekly basis regardless of market conditions. While these strategies may minimize risk, DOVs are still dependent on market conditions.

Put simply, covered calls are riskier during bullish markets while protective puts are riskier during bearish markets. Covered call strategy faced a significant loss (especially in early 2021) when ETH jumped from $740 to $1200 in less than a week. Black swan events like this tend to be infrequent but significantly erode the strategy’s profitability. When the contracts being traded through these strategies expire ITM, it is the investors’ capital at risk, resulting in extremely low APYs and even principle risk.

However, these risks can be counteracted by simply accounting for market conditions before trading for strategies. DOVs should analyze the market through discretion, considering the option type, strike, maturity, and market factors, to trade rather than just employing automated strategies. For example, to predict extreme events, vaults can analyze the ETH price/option strike ratio. If the ratio is greater than 1, it indicates the sold call option is ITM whereas a ratio less than 1 indicates the option is OTM. This quantitative analysis can be done through a combination of oracles, on-chain data analytics, and well-built code.

If DOVs begin analyzing options and the market before trading through covered calls or protective puts, it may result in higher profitability for everyone!

Illusion of ‘Good’ Yield is ‘Bad’

Some of the protocols selling certain strategies in DOVs have been found to advertise fake high yield to make their vaults attractive. Who doesn’t like double digit APR in a risky environment? There are a number of ways to fake/tweak the numbers from excluding the loss from in-the-money weeks to only calculating the yield as an average of past few weeks (which necessarily smoothes any downfall).

Hence there’s a need to do away with the tradition of faking the actual numbers. True yield along with all the associated risks must be flashed on the UI to make the whole process transparent for investors. Doing otherwise is simply predatory.

Integrate Cross-chain Liquidity:

While “omnichain” or “crosschain” have become buzzwords for the NFT-enthusiasts, they are especially important in the context of DeFi. With capital in DeFi split across so many chains resulting in liquidity fragmentation, it’s necessary for any DOV to be functional across chains to their best extent.

There are two ways a DOV can be cross-chain: deploy on other chains or make use of cross-chain liquidity aggregators and Layer Zero. While deployment is typically preferred by most DeFi protocols, it could be expensive owing to the number of virtual machines and various deployment costs. Instead, making use of protocols like Layer Zero or 1Inch would allow for DOVs to maximize their capital and consequently their profitability.

Allow for LP Tokens Deposit

Most DOV deposits are typically single-asset: ETH, MATIC gOHM, etc., and there’s nothing much to it. If DOVs would allow for users to deposit their LP tokens (Polysynth, for example), this would allow for users to yield farm while unlocking liquidity for them to earn from option premiums as well. A protocol named Rage Trade approaches the deposit of LP tokens quite similarly through their “deep liquidity” functionality — LP tokens are used to dynamically unlock liquidity for perp trading as asset prices (and perp prices) increase and decrease.

Conclusion

The appeal of DeFi option vaults is tremendous. The current strategies that the vaults offer are just vanilla puts and calls, but these will gradually become complex in the future. The product’s structure will make it very difficult to use the vaults as a hedging tool. However, the protocols will be very approaching for bootstrapping liquidity for the options market, eventually making decentralized options more viable.

DOVs are an essential step toward democratizing finance for the masses. They also play a leading role in increasing demand for organic yield. Therefore, they address the issues of the unsustainable and circular yields that DeFi currently faces. Many of us have imagined the allure of AI and tech making their way into the financial industry — most people even believe the work of analysts and researchers to become obsolete as technology continues to develop. When you combine the benefits of automation in finance with decentralization — you get a DOV.

Authors:
This research article is authored by Polygon DeFi researchers: Eshana, Akhil, and 0xlol in association with Paradigm Trading. Eshana is a quantitative finance research intern at Polygon, and is a finance and computer science major at NYU. Akhil (Twitter) is a DeFi research intern at Polygon, and studies finance, math and computer science at NYU Stern. 0xlol (Twitter, Github) heads DeFi research communications at Polygon, with their research interests in DeFi derivatives, Web3 Infra, and Layer 2 Scaling Solutions.
Cover Picture Art: Darshan (Illustration) and 0xlol (Conceptualization)
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