In recent years, options contract trading has exploded. In fact, 2022 was the third straight year that US single stock and index options contracts set a new record, more than doubling from three years ago.
Last year marked the first time US stock options exceeded 10 billion contracts in one year. Although options are also available on cryptocurrencies, they lag far behind stock options in popularity. According to Wave Financial, the daily volume of crypto options on centralized exchanges hovered just under $1 billion.
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On-chain options take it a step further, but they are still far less popular than daily crypto options, accounting for less than $10 million in daily volume. As a result, Wave Financial stated earlier this month that on-chain options are “the next frontier in DeFi.”
What are on-chain options?
Options are contracts that give the holder the option, but not the obligation, to buy or sell the underlying security at a specific price on or before a specific date. Call options allow you to buy at the specified price by a specified date, while put options allow you to sell at the specified price by a specified date.
When an option is referred to as “on-chain,” it is a contract that has been recorded on a blockchain. Buying on-chain options requires a protocol like Hegic.
Some investors buy options to hedge against potential volatility, even though volatility is practically a given in cryptocurrency. Others buy them as portfolio protection because they could allow them to sell their assets at a price higher than what the broader market is selling at. Another common reason for buying options is to earn a return by selling options and collecting a premium in return.
In recent years, much of the growth in decentralized finance (DeFi) has come as a result of expectations for institutional investors to become major players in the market. However, traders have yet to take full advantage of on-chain options.
A changing landscape
On the one hand, it’s easy to see why off-chain options are more popular these days. There is inherently more available off-chain liquidity, and there is a wider range of maturities and strike prices available via off-chain options. According to Zee Prime Capital, on-chain protocols may only offer one or two short expirations with only three to five strike prices.
However, the options landscape in DeFi has been changing rapidly, and the last 12 to 18 months have been crucial for this asset class. Hegic was the dominant options protocol in early 2020, trying to create pools of liquidity to sell calls and puts.
Three years later, the on-chain options landscape includes various forms of protocols, which Zee Prime categorizes as liquidity pools, order books, structured products, and sustainable return products. One of the most popular groups of protocols are structured products, better known as vaults.
structured products
They allow users to sell volatility in various ways such as: B. by underwriting covered calls or protected puts. In return, users receive a bounty that some see as an alternative to liquidity mining. Just like other options strategies, investors using this options protocol do not need to do anything after the initial deposit.
Most options expire at the end of the week and strike prices at 10% to 30% off spot are preselected and automatically rolled by the protocol. Not surprisingly, Ethereum and Bitcoin are the most popular underlying securities for these options protocols, although options on a select number of other crypto assets are also available.
Zee Prime Capital observed a recently developed options-related trend that is dampening short-term implied volatility due to strong selling of protocols that fall into the structured products category. The company noted that off-chain market makers buying these options need to hedge by selling similar options on Deribit.
As a result, it suggested that natural demand may not be large enough to absorb the growing aggregate value locked in structured products. Zee Prime Capital assumes that interest in structured products will continue to grow due to the attractive returns. It also noted that some protocols were beginning to address the issue by allowing investors to bid on-chain while competing with market makers on pricing.
Another problem for structured products is that volatility decreases around the time the weekly premiums are auctioned. Market participants know that there will be heavy option selling at this point, so they are pushing implied volatility down, resulting in less returns for structured product users.
As a result, protocol users and developers have to deal with various issues during this time of growing pains. For example, they need to consider whether to take more risks, which can be done in a number of ways, e.g. B. by drawing the options closer to the at-the-money level to offset the compressed return.
On the other hand, market power could be allowed to naturally balance supply and demand instead of selling volatility. For example, Fritction is already working to address this by experimenting with different auction times for different assets throughout the week. These experiments aim to capture higher implied volatility.
Potential issues with on-chain options
As the number of on-chain option protocols grows, it should become clear which ones hold more promise than others. However, no asset class is perfect, so investors should also learn about the risks associated with an investment before making a purchase.
Zee Prime Capital noted that options have been growing faster than other DeFi products until recently. However, the difference was relatively small considering the number of users, options versus spot volumes, and other issues.
For example, liquidity is always an issue in the early days of an asset class, and on-chain options are no different. Zee Prime pointed out that traditional market makers may need a single trading venue with greater liquidity that supports multiple derivative products while allowing for under-collateralization with cross-margining. Several protocols are doing this on the Solana blockchain, and the company expects them to gain significant traction over the next year.
Of course, most options expire worthless, so on-chain protocols must protect investors at the expense of capital efficiency, liquidity, and price discovery. Gas fees are a significant obstacle, especially as they have been rising recently. Most options protocols were built on top of Ethereum amid rising gas prices, and options are particularly sensitive to gas fees as the premiums are comparatively small in dollar terms.
Finally, decentralized market makers need to be hedged so that they can provide the liquidity to write options and sell them both ways. This issue also needs to be addressed via the options protocol, which can be challenging.
Some ideas for on-chain options
Going forward, Zee Prime Capital expects more products to be developed to unlock the crypto-native revenue streams like staking. In turn, the company also noted that selling option premiums for income is not a sustainable strategy over the long term. As a result, she expects that all structured product protocols will eventually build sustainable return products.
The company also predicts that on-chain options will be more tightly integrated with other DeFi use cases. Automated market makers, money markets, and perpetual futures markets could all theoretically drive their own liquidity and adoption by adding options to help with risk management. This would create a natural demand for on-chain options.
Have you invested in on-chain options? Share your insights in the comments section below.
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