Cryptocurrency itself is an asset with extremely high volatility. Supporting high-leverage futures contracts can easily bring crypto investors the potential to get rich overnight. Of course, users may also fail to control their positions and suffer from violent market fluctuations, which is extremely risky and has no lower limit on losses. However, relatively speaking, the risks of option products are more controllable, and the right of choice lies more in the hands of users who purchase options. That is, investors who purchase options can choose not to exercise their options when the market is unfavorable, and the premium paid is their maximum possible loss, so users can minimize their losses.
In traditional financial markets, the market size of options and futures contracts is on par with each other, but in the crypto market, options have always been lukewarm.
In fact, as early as 2015, crypto derivatives (options, contracts) based on Bitcoin assets were already available to the market. After the Chicago Mercantile Exchange launched Bitcoin futures products in 2017, crypto contract products were continuously introduced by major early CEXs and continued to grow. Especially after 2018, crypto contract products have become an important product for major CEXs to compete in the market and capture incremental users.
Crypto options started relatively late, and after futures contracts took over the market and the minds of crypto players, the trading volume of options market and futures market was very different. For example, the trading volume of Bitcoin options market in December was only 38 billion US dollars, while the trading volume of Bitcoin futures contracts (mainly perpetual products) in the same month was about 1 trillion US dollars.
Bitcoin options trading volume
In the options market, CEX platforms have always occupied a dominant position. We see that Deribit, whose biggest selling point is options, has a market share of about 80% in Bitcoin options trading in the segment (currently, the open interest of Bitcoin options alone has reached US$16 billion). In addition to Deribit, the share of transactions in the options field of Delta, OKX, etc. is also steadily increasing, and the head effect is serious.
Another trend is that after the DeFi Summer, the development of a more composable and programmable DeFi world is accelerating the continuous innovation of on-chain finance, and the on-chain options market has also begun to evolve towards the product form of DeFi.
On-chain options
After 2021, some synthetic asset protocols began to act as underlying protocols, such as OPYN, Hegic, Synthetix, etc. They can help investors cast their assets into option tokens. These minted tokens will be able to be further traded in other protocols, including exchange, exercise, etc. Driven by the underlying option protocols, more and more developers are beginning to flock to the on-chain options field and develop upper-layer protocols in a composable way, such as Ribbon Finance, Lyra, etc.
In fact, the sources of liquidity for on-chain protocols are usually dispersed. For example, AMM DEX represented by Uniswap and on-chain perpetual protocols represented by GMX can distribute income to LP in exchange for liquidity driven by a large number of active traders. However, the options sector, especially the on-chain options sector, is a niche market (of which the AMM model accounts for a high proportion). When the overall market size is small, it is difficult to bring considerable benefits to the protocol to maintain liquidity.
We have seen that in early AMM option protocols such as Hegic, Dopex, and Premia, LPs have accumulated high exposure to the underlying assets because the collateral is not hedged, which further increases the liquidity cost of LPs when the incentives are not high, hindering the growth of the liquidity pool. Even though Lyra, Dopex, and Siren Flow have made improvements to the AMM mechanism, improving capital efficiency and bringing a better trading experience, there are still liquidity problems.
From another perspective, the appeal of some option players is not to make profits, but to hedge risks, but most option products lack strategic grasps. The on-chain option product system is more oriented to C-end users, and it is difficult to help B-end users such as crypto projects, DAO organizations, and VCs to better manage assets in the form of option products, which also leads to the slow growth of the overall market size of on-chain options (accounting for less than 7% of the overall on-chain derivatives market). From the perspective of traders, on-chain option products not only lack liquidity and have a poor trading experience, but are also easily subject to time constraints and are very likely to face the loss of time value under the influence of volatile markets.
Even if we assume that the market share of on-chain options will reach a similar level as on-chain perpetual contracts, the estimated daily trading volume of on-chain options should be around US$800 million to US$1 billion (based on the monthly trading volume of the on-chain derivatives market of US$30 billion). This may still not be enough to incentivize market makers to make markets on the chain. Therefore, given the particularity of the options market itself, further innovation in product mechanisms is needed to achieve better product effects.
In fact, if the idea of building option products is changed, good results may be achieved. Smilee Finance, an innovative on-chain option product, has proposed a new option solution, which attempts to use the large number of short option positions in the centralized liquidity pool in AMM DEX such as Uniswap v3 to build its derivative primitives and convert the uncompensated losses faced by LPs (liquidity providers) into uncompensated gains, which means that as long as there are LPs providing liquidity, it can be regarded as someone casting options. This may be a brand new beginning for opening up the on-chain option market.
Smilee Finance's Options Exploration
Smilee Finance is an on-chain options protocol built on AMM DEX, which abstracts the uncompensated losses of LPs in AMM DEX and decomposes them into option products to be sold to option investors. The fees paid for purchasing options are returned to LPs as compensation for uncompensated losses.
Therefore, the options protocol built by Smilee Finance mainly includes the following roles:
●Short volatility role - LP
LP provides liquidity for AMM DEX by injecting assets into the liquidity pool in proportion. Generally, the smaller the market volatility, the smaller the uncompensated loss of LPs, and the higher the overall return. This means that in the concept of options in Smilee Finance, the LP role is a role that prefers to short volatility (also known as short-term volatility DVP in Smilee's cryptographic primitives), and they are also the minters of options.
● Long Volatility Role – Option Buyer
Correspondingly, option buyers on the other side of Smilee Finance can only obtain substantial returns when the market fluctuates, so option buyers play the role of long volatility in Smilee Finance's option products (also known as long-term volatility DVP in Smilee's cryptographic primitives).
Therefore, after the short-term volatility DVP (LP) of Smilee Finance option products is minted by Smilee, Smilee will cast its potential uncompensated losses into options for sale, while the long-term volatility DVP will purchase these options through Smilee through assets such as USDC. The premium assets paid by the long-term volatility DVP will be distributed to LP to compensate for their uncompensated losses, and the long-term volatility DVPs will obtain these uncompensated loss assets in the form of options (absorbing the uncompensated loss risks faced by LPs).
At the same time, in a pair of Smilee Finance-based and user-oriented vaults, its two sides will contain volatility exposure (long volatility or short volatility), token pairs (such as ETH/USDC), return formulas, the strategy behind DVP and the formula used to achieve the vault's goals, option expiration dates, auction cycles, and several optional option elements.
Therefore, for LP users, they can receive compensation that can cover the uncompensated losses (the funds used by option buyers to purchase options) after incurring uncompensated losses. Whether option buyers can make a profit depends on market fluctuations. If the income obtained when the option is exercised is greater than the premium paid when purchasing the option, then a profit can be achieved.
Usually, in a constant AMM DEX, as long as there is LP providing liquidity, there will be uncompensated losses. This means that the liquidity of Smilee Finance options itself comes from the underlying AMM DEX, such as Uniswap, SuiShiswap, etc., and it also solves the problem of "which came first, the chicken or the egg" in the options field.
In fact, the sum of short-term and long-term volatility DVP returns is itself the sum of LP returns and impermanent losses. Therefore, for Smilee Finance's trading engine itself, it can ensure that long-term volatility and short-term volatility DVP are perfectly balanced, that is, ensuring that the liquidity of each vault is perfectly matched with the allocation of the weighted portfolio, and ensuring that all DVP returns are fully protected.
Smilee Finance represents a new set of underlying protocols for options solutions. On Smilee Finance, developers can further develop different types of options vaults or applications with functional hooks, such as establishing options libraries for execution calls, put options, straddles, or any other types of options strategies to meet the needs of different user groups. For example, crypto projects, VC users, DAO organizations and other roles who want to avoid LP risks, hedge market risks, establish strategy returns, etc. can all get support from Smilee Finance.
In addition, Smilee Finance is also one of the solutions for DEX to capture liquidity. By introducing this set of capabilities into different DEXs, it will be able to achieve a better long-term capture of liquidity by increasing LP returns. Smilee Finance's option solution is also one of the best solutions in the option system currently established based on AMM.
In May 2023, Smilee Finance received a seed round of financing of US$2 million led by Dialectic, with participation from many investors including Synergis Capital, Concave Ventures, Owl Ventures, Yunt Capital, Dewhales Capital, Outlier Ventures, New Order, Multisig Ventures, GTS Ventures, Hyperpyra and a series of angel investors.
Use cases for real income vaults and free income vaults
At present, based on the underlying Smilee Finance protocol, which is based on Uniswap v3, two specific use cases have been launched for LP users and option investors: real income insurance vault and free income insurance vault.
The real income vault is mainly for short-term volatility DVP, i.e. LP role. It supports LP users to pledge single or dual currencies into the vault, and can obtain a clear return expectation from the vault (from the premium paid by the other side of the vault), and can also obtain LP income. The Smilee Finance team has tracked the income of the real income vault and compared it with the income of direct market making in Uniswap v3 under the same conditions.
The results show that under the same conditions, in terms of profitability, the Real Yield Vault can ensure that no matter which direction the token fluctuates, LPs can almost always obtain returns far higher than directly making markets in the AMM DEX.
The Free Return Vault is the other side of the Real Return Vault, that is, option buyers can pay the premium in USDC and purchase options (free losses from the Real Return Vault). Option buyers can choose the asset floor, premium amount, strategy, expiration date, and auction cycle, and can even increase leverage (up to 1000 times).
When option buyers pay a premium to purchase options, they can only make a profit when the value of the free loss assets they obtain is greater than the premium paid when exercising the option. Smilee Finance has calculated the actual profit mathematical model for a specific pool in the free income vault. The results show that through this pool, option buyers will be able to obtain higher profit expectations and cover the premium paid after purchasing options when the underlying price rises by 13% or falls by more than 12%.
Therefore, in theory, after purchasing the option rights under this strategy, the more violent the market volatility, the higher the expected profit of the option buyer. In fact, for option buyers, it is not necessary to exercise the option in a fixed period. In order to make up for the loss, they can also exercise the option in advance to stop the loss in time, but they will directly lose the premium paid.
Of course, based on Smilee Finance, you can also choose or establish a vault that is opposite to the free income vault strategy, so that investors with specific needs, risk averse people, etc. can execute strategies through this new option solution (different pools have different yield curves). This also means that more specific application pools with more functional grippers will appear in the future, bringing more strategy execution options to investors.
In terms of market share and overall trading volume, the options track, especially the on-chain options sector, is still in a very early stage. The track also shows many shortcomings such as insufficient inclusiveness, poor trading experience, and lack of scalability. Smilee Finance represents a complete set of flexible options solutions. By building on the free loss of AMM DEX, it is making options a new concept and has a new means to solve a series of practical problems. Therefore, there is no doubt about the long-term development potential of Smilee Finance.
