The easy-to-navigate nature of DeFi Option Vault (“DOV”) UXs allowed them to gain product-market-fit in 2021/2022 — although the subsequent bear market in 2022/2023 highlighted certain shortcomings with their design that eventually led to them losing favour with the market.
This article seeks to examine DOVs in an objective manner, and is the first of a two-part series covering Thetanuts Finance’s transition from a DOV to a decentralized options marketplace.
An Option 101 Primer
This section aims to provide some insight on options as an asset class. Some key terms that will be important for understanding options:
- Underlying Asset: The asset in which a derivative instrument (i.e. an option) is based off of.
- Strike Price: The price at which the underlying asset can be bought or sold once an option is exercised.
- Option Tenor: The length of time until option expiry.
- American Style: May be exercised any time before the expiration date.
- European Style: May only be exercised at the expiration date of the option, i.e. at a single pre-defined point in time.
- Settlement: The process of fulfilling the terms of an options contract when the option is exercised — options may either be cash-settled or physically-settled.
- Physically-settled: Involves the physical delivery of the underlying asset (i.e. $ETH) on the settlement date of the options contract.
- Cash-settled: Involves the delivery of the net cash amount on the settlement date of the options contract.
- Volatility: Statistical measure of dispersion of returns for an underlying asset, often measured from standard deviation or variance between returns.
- Implied Volatility (“IV”): Estimation of the future volatility of the underlying asset. Implied volatility is a key component to option pricing.
- Black-Scholes Model: The mathematical equation that estimates the theoretical value of an options contract — computed using strike price, price of the underlying asset, option tenor, risk-free interest rate, and implied volatility.
To understand DeFi options, it’s also important to understand option structures and payoffs.
- Long Call: Buying a call option gives the right to buy the underlying asset at the strike price upon option expiry.
- Long Put: Buying a put option gives the right to sell the underlying asset at the strike price upon option expiry.
- Short Call: Selling a call option creates an obligation to sell the underlying asset at the strike price upon option expiry to the buyer of the call option. In exchange for selling the call option, writers (or sellers) receive an option premium.
- Short Put: Selling a put option creates an obligation to buy the underlying asset at the strike price upon option expiry to the buyer of the put option. In exchange for selling the put option, writers (or sellers) receive an option premium.
How do DOVs work?
DOVs sell out-of-money (“OTM”) European cash-settled options to accredited market makers, and generate yields for users in the form of option premiums. Vaults have pre-defined parameters (inc. strike price, delta, and tenor) — creating specific risk-adjusted yields on each vault, while also abstracting the complexity in users needing to design these parameters on their own.
Across most DOVs, there are two main option strategies:
Selling Covered Calls: User holds a long position in the underlying asset, and also sells OTM call options. Designed to generate income for users.
- Users deposit the underlying asset (i.e. $ETH) into the vault, and receive an option premium for taking on risk that the option will be in-the-money.
- If the option is in-the-money at the end of the tenor, the market maker (i.e. call option buyer) can exercise the option.
- When exercised, the vault has the obligation to sell the underlying asset (i.e. $ETH) in the vault to the market maker at the strike price. Users in the vault will lose part of their deposited $ETH collateral, and receive $USDC.
- If the option expires out-the-money — option premiums are reinvested into the vault, compounding yields for users over time.
Selling Puts: User sells OTM put options without shorting the underlying asset. Designed to accumulate the underlying asset for users.
- Users deposit the stablecoins into the vault, and receive an option premium for taking on risk that the option will be in-the-money.
- If the option is in-the-money at the end of the tenor, the market maker (i.e. put option buyer) can exercise the option.
- When exercised, the vault has the obligation to buy the underlying asset (i.e. $ETH) from the market maker at the strike price.
- Users in the vault will lose part of their deposited stablecoin collateral, and receive $ETH.
- If the option expires out-the-money — option premiums are reinvested into the vault, compounding yields for users over time.
As users receive option premiums for selling option contracts — accredited market makers (i.e. QCP Capital, GSR, Wintermute) are on the other side of the trade purchasing these option contracts. To facilitate this, DOVs conduct a blind auction every Friday (timed alongside Deribit’s Friday settlements) — where market makers compete and provide best bids to access the TVL in the vault. Upon conclusion of the blind auction, the winning market maker deposits the option premiums into the vault.
Why were DOVs so popular?
DOVs performed well in 2021/2022 for a few reasons, hitting a peak TVL of $550mm in April 2022.
Higher Volatility & Higher Premiums
Market volatility was much higher in 2021/2022, resulting in higher option premiums for users. In Jan 2022, the $ETH Covered Call vault on Thetanuts Finance generated ~30% — compared to ~9% today.
Multiple Sources of Yield
From a narrative perspective, DOVs were marketed as having multiple sources of yield — 1) yield from option premiums, 2) token emissions, and 3) additional staking rewards from vaults with staked assets (i.e. $stETH, $rETH) as the underlying. While the term #RealYield is used frequently today, DOVs were one of the first proper implementations — where they were marketed as having “Organic Yields” that were not emissions-focused.
Appetite for Yield Strategies
Digital asset markets in 2021/2022 were characterized by leverage and ease of credit, largely enabled by aggressive lending desks (i.e. Celsius and Genesis). This had spillover effects on other parts of the market — where yield-focused strategies were viable and had compelling risk/reward, including deploying capital into DOVs.
Shortcomings of DOVs
Unattractive Risk/Reward
With lower market volatility today, users also earn lower yields — the $ETH Covered Call vault on Thetanuts Finance currently generates ~9% (vs ~30% in Jan 2022). Given that users take on risk that the option will be in-the-money and may thus lose part of their collateral — users may instead consider deploying their assets into risk-free instruments like 3mo U.S. Treasuries that yield ~5.5%.
Sell-side only & Inability to Exit Between Epochs
DOV strategies mainly center around the sell-side, by selling covered calls or selling puts — users of DOVs thus have no means of going long on options. Furthermore with a limited withdrawal window every Friday — we see that users have little liquidity in between epochs, even if they require the capital to deploy elsewhere.
Not a Leave & Forget Strategy
Through DOVs, users sell out-the-money options and receive option premiums for doing so — with the option premiums being reinvested into the vault, compounding yields for users over time. While this mechanism encourages users to leave their collateral in the vaults in a “Leave & Forget” strategy, users still bear the risk that large price movements in the underlying asset could cause them to lose part of their collateral. Furthermore, DOVs run the same strategies regardless of market conditions — where the burden is on users to find the right DOV strategy. We see a movement toward users interacting with DOVs in a more nimble manner — moving their collateral in and out of vaults depending on their view of markets.
Professional Market Makers as the Counterparty
As DOVs mature, users also understand that their counterparty on the vaults are professional market makers — who are highly sophisticated market participants. While there is no evidence of this, these market makers are accused of front-running or low-balling during the blind auctions — resulting in users receiving lower option premiums.
How do market makers front-run auctions?
Most DOV blind auctions are conducted every Friday, timed in conjunction with weekly options expiry on Deribit. With these weekly auctions, we see ~$50mm of crypto options being sold across DOVs within the same delta range and expiry — resulting in IV compression due to the systematic selling of volatility, resulting in lowered yields for DOVs. According to Glassnode data, IV of $BTC and $ETH options on Fridays and Saturdays are 10–15% lower than that of other days.
Given the public nature of these auctions (with contract sizes, delta range, and expiries being known), market makers can also opportunistically front-run these auctions by going short on volatility ahead of Friday auctions. These positions can then be closed after the auctions, with flows being easily managed given the Friday activity on Deribit. This front-running activity further compresses yields for DOVs.
Unattractive for Professional Market Makers
On the other hand, professional market makers have also lost interest in DOVs.
- Lack of Capital Efficiency: Market makers have to fully deposit the option premiums into the vault every Friday, and are unable to use any positive P&L for portfolio margining — which effectively limits capital efficiency.
- Small Size: Notional value of DOVs are relatively small, limiting the how much capital these market makers can deploy — and making them unable to participate in big size. However, we see this is a “chicken-and-egg” issue — notional value of the vaults is kept small so that market makers have appetite to bid during the blind auction.
Conclusion & Prelude to Part Two
Market participants have observed a number of issues with DOVs, resulting in a challenging environment for DOVs to operate going forward. We see a number of DOVs ceasing operations, while others have pivoted to other parts of the derivatives market.
Likewise, Thetanuts Finance recognizes the challenging operating environment in playing within the DOV space — and will be pivoting to becoming a decentralized options marketplace, allowing users to long or short on-chain altcoin options.
We’ll publish Part Two of this two-part series covering Thetanuts Finance’s transition from a DOV to a decentralized options marketplace.
