Applications of Staking Options in Decentralized Finance
Staking Options (SOs) as first devised in the Dual Finance whitepaper, will have far reaching effects across the Decentralized Finance (DeFi) ecosystem as it becomes the integral component to and the industry standard for optimally designed token incentive structures. This simple, yet key innovation is crucial in the economic game theory underpinning tokenomics to align incentives of normally adversarial market participants. Current Proof of Stake as well as farmed incentives in truth are not a positive return for stakers, but a negative cost for any non-stakers whose purchasing power is continuously inflated away. As opposed to an inflationary mechanism issuing free tokens for short lived cash grabs by early users, team members and investors, Staking Options have higher dimensions of configurability and generate forces to improve project longevity. Before that discussion however, let’s review the principles of SOs.
What are Staking Options?
Staking Options are an incentive mechanism that grant participants who lockup their liquid tokens, the right, but not the obligation to trade tokens at a future price. SOs are considered an incentive mechanism because they are issued for participation in staking or locking up tokens, rather than a financial option which requires a premium payment. In that sense, the payment is the token lockup, rather than a cash premium. Therefore, Staking Options are free options rewarded for taking your liquid token supply off the market or, as we’ll see for participating in other supportive protocol activities.
Tokenomic Design Space
Staking Option Parameters:
1. Lockup Ratio (LR)
2. Pool Size
3. Maturity Ratio (MR)
4. Strike Price
5. Type (Call SO or Put SO)
6. Style (American SO or European SO)
Staking Options are configurable across far more parameters than standard inflationary staking, which is just a Rate (= Reward Tokens/Time) modeled as an APY. A smart contract can be configured to determine the ratio of lockup quantity to option contracts granted, the Lockup Ratio (LR) = Option Contracts Granted / Token Lockup. Lockup ratio can be defined by a function rather than a fixed percentage. Additionally, Pool Size defines the max amount of options contracts allocated to a SO. Lockup ratio in conjunction with Pool Size are the most significant of the SO parameters as it determines a potential inflation rate.
Maturity is configurable as a ratio of lockup time to option maturity, the Maturity Ratio (MR) = Days Tokens Locked Up / Days Until Option Maturity. While configurable in most applications it’s simplest to assume the ratio is 1, that is the Lock Up = Days Until Option Maturity. Third is simply the Staking Option’s strike price, the price at which the holder has the right to buy or sell the SO. The Strike does not have any ratio based determination from the initial stake, but should be parameterized by a moneyness relative to spot price at the end of a deposit period. Strike price & Maturity Ratio will determine the probability that an SO is exercised, thus impacting token inflation rate.
Staking Option type is whether the incentive is a call on the future appreciation of the token or a put to protect users from negative price action. Last, Staking Option style is configurable between American, holders may exercise at any time and European, holders may only exercise at expiration. There are merits to both so the choice between the two is important. American style will potentially allow for a more even distribution of token supply release if holders choose to early exercise, while European will constrict supply to the maturity date usually in tandem with the lockup becoming liquid again.
The implications of these configurable parameters mean there is a wider design space for project founders who are considering their tokenomics. In fact, any traditional option concept can be effectively extended to Staking Options. While outside the scope of this discussion, there is a realm of Exotic Staking Options that deserves detailing in the future. Consider Asian SOs, Knock-Out/In SOs, Binary SOs etc.
(3,3) for Staking Options
Popularized by the Ohmies of Olympus Dao, (3,3) has become a crypto meme to represent the perfect game theory strategy to counter the inflationary nature of OHM and related tokens; similar in some ways to the Bitcoiners warcry of “HODL!”. The basic thinking is simple: if none of us sell, but instead buy and lockup tokens, removing supply, those actions are the most mutually beneficial outcome as it leads to the most price appreciation. Yet there is one fatal flaw in this game theory, it does not consider the time horizon over which the game is played. Ultimately the participant who is first to sell wins, potentially cascading its effect until the entire system implodes. Critics may refer to this as a ponzi scheme, while others in the WAGMI camp will reap the rewards while the music continues playing.
Staking Options present a new paradigm of incentives. Effectively, WAGMI but even more when the token appreciates. From a game theory perspective SOs may be considered (9,9). Our incentive is to buy a token, stake a token, and contribute to the overall robustness of the network and project. Otherwise the Staking Option will never realize its full potential value. Not only do SOs lockup token supply via the stake as a premium payment, but also confer a non-inflationary effect if not exercised. SOs that expire out-of-the-money are marginally beneficial to a project as the supply remains with the treasury and indirectly owned by the remaining token holders or DAO. Any unexercised supply can be used to increase future SO Pool Sizes. Also consider a SO that is marginally not worth exercising, so the price at expiration is just at or below the strike price. While SO holders will choose to not exercise, their staked tokens have appreciated considerably and the treasury has not been reduced. In this manner, it’s a win-win; the treasury is able to extract the maximum value from its token supply and holders still profit.
Treasury Management Strategies
New and established projects may find they can only offer viable Call SOs since the main asset the treasury has is its own tokens. From the perspective of public token sales, issuing Call SOs is a useful way to capitalize a treasury with above current market sales. While issuance of SOs is free, the exercise of them is not. Holders need to actually pay stablecoins in the amount of the Strike Price * Quantity of SOs to realize any profit on the incentive. Therefore, if the token appreciates and the project uses SOs as a main incentive mechanism, a treasury over time will naturally accrue and diversify itself into stablecoins. Later in a project’s life cycle, once it has significant stablecoin reserves, it may make sense to begin offering Put SOs to network participants. Again participants will stake their tokens, possibly with a higher LR than Call SOs as means to protect their downside risk. If the long term value of the project is well justified, then from a treasury perspective this is not an issue. The treasury will soak up its own excess tokens at a discount to current prices in the event of assignment. Ultimately, Put SOs offered by well capitalized treasuries bestow confidence in their token holders that any investment in the token is safe and if not it will be bought back. Crypto markets are prone to high volatility, but by offering Call and Put SOs a treasury can bring price stability to its token market and deeper liquidity for its holders.
Natural Market Making
By virtue of the risk characteristics of Staking Options, token volatility can be expected to decrease and book liquidity to increase when issued as part of incentivization structures for projects. As a project treasury issues SOs, they are effectively selling volatility, meaning the treasury is better off when markets are calm and SO holders are better off when markets are unstable. In the absence of any risk management on either side, price is unaffected. However, in practice holders of the options will want to capitalize their unrealized gains over the lifetime of the SO. This means if token price appreciates, the SO holders will likely sell tokens into the market and then if the price sells back off, they will buy some tokens back from the market. Across many SO holders and across many strikes and maturities, the effect this has is to reduce net volatility. As price rallies there are natural sellers, as price sells-off there are natural buyers. This also means that regardless of whether SOs expire in-the-money or out-of-the-money holders should still profit from this natural buy low, sell high risk management strategy. For options traders this is known as positive gamma trading or gamma scalping, which is a mean reversion trading strategy on the back of owning long options. Without belaboring the point, this provides natural market making for a project. Therefore SOs can significantly increase a token’s underlying liquidity and price stability when well distributed across many participants, strikes and maturities.
Impermanent Loss Mitigation
Automated Market Making (AMM) on Decentralized Exchanges (DEXs) are known to be losing strategies broadly as the models used are over-simplifications of complex liquidity providing programs on highly volatile crypto assets. Impermanent loss as it’s widely known in crypto is merely a euphemism for bad trading. There may be exceptions to this when projects deploy a farm atop a DEX liquidity pool. However, currently in DeFi, farms simply pay token rewards often with insanely high inflation. Applying Staking Options instead to this incentive provides a unique ability to hedge some of the impermanent loss exposure present in AMMs. This SO modification introduces Liquidity Staking Options (LSOs) as they are issued, not for locking up the project token, but for providing a useful service to a project like improving token liquidity. By issuing LSOs instead of just tokens, projects will achieve higher Total Value Locked (TVL) in DEX AMMs. In the same manner as normal market making, Staking Options provide holders more staying power in their positions and are better able to weather highly volatile markets. Through the positive gamma profile of SOs, liquidity providers will be able to mitigate the impermanent loss and constant negative gamma associated with constant product AMMs.
Default Rate Reduction
For DeFi lending protocols, projects can contribute to lower default rates on their token if borrowers and lenders are able to earn SOs. In the event an over-collateralized borrower sees the value of their project token borrow increase relative to the value of their collateral, rewards in American style call LSOs can prevent liquidation. The borrower can exercise their LSO at any time when the project token has appreciated and more easily re-collateralize their position. Conversely, put LSOs awarded to lenders would reduce the default rate and liquidation likelihood when a project token used for collateral falls relative to a borrow. The reduction in default rates and liquidations makes for a more robust token price, especially when considering the frequency of cascading liquidations in crypto. SOs incentives in DeFi lending and borrowing can reduce spreads and increase willingness of participants to extend credit and facilitate new financing opportunities.
Structured Product Hedging
In the case of its creator Dual Finance, Staking Options can have even more direct uses like cross-asset volatility hedging. For any Structure Product Pool (SPP) whereby stakers gain yield by selling optionality on an asset other than the project token, SOs can be viewed as a natural hedge. Dual Finance’s application of LSOs offset the risk of its Dual Investment Pools (DIPs), a covered option position being exercised. Participants are effectively short yielding token options, and long project token options. The quality of the hedge is a function of the correlation of the yielding token and project token. The higher the correlation, the better the assumption holds that if assigned on the yielding token option, the project token option will also be exercisable. For options based protocols, SOs incentivize greater TVL, not just by higher net effective APYs, but also because less volatility or vega risk is being taken in aggregate. In this sense, SOs defy the principles of traditional finance, users can have higher returns and less risk.
Creation Platform
With the goal being to seamlessly reinvent DeFi incentive structures, Staking Options will be available for creation via Dual Finance. Projects will be able generate their own smart contract to deposit and offer SOs to their community directly on their own DApps and hosted on dual.finance. The service will be provided with a non-technical, fully customizable platform to mint SOs. Fees for the creation and hosting service will be taken in a small proportion of the Pool Size of each project’s SO generated.
The platform will offer two varieties of SOs. The first, earned for locking up project tokens will be named for clarity General Staking Options (GSOs). The second, earned for participating in a project’s product or improving liquidity are Liquidity Staking Options (LSOs). Recall Dual Finance’s DIP, DeFi Lending and DEX AMMs applications of LSOs. The difference is just the asset that is considered for the Lockup Ratio. GSOs are applicable to only staking the project’s own token, where LSOs are more relevant anywhere that various yielding or liquidity pool tokens are minted for the project’s benefit.
Secondary Market
Naturally SOs will spawn a derivatives market for tokens that may not otherwise have options trading. Some SO holders will demand instant liquidity and inevitably try to sell their rewarded SOs immediately upon being awarded, rather than wait until the maturity date to potentially exercise. Dual Finance will provide the marketplace to facilitate these trades. By doing so, this SO secondary market will lead to price discovery of the token’s options and implied volatility market.
Despite users being able to potentially sell accrued SOs to stablecoins immediately, that does not mean a project’s treasury is giving up their value meaninglessly. Rather a liquid secondary market adds value for the projects using SOs, since they can better gauge the total value of the incentives being offered. This pricing information allows projects to iteratively design their SO incentives to maximize the participation and utility gained. While it may be assumed that everyone will want immediate liquidity, this would lead to the SOs being sold too low. At that point, a price efficient secondary market allows savvy traders to scoop up the discounted SOs to try to monetize via gamma scalping. Whoever ultimately ends up with Staking Options from the secondary market will be incentivized to provide liquidity and see the project succeed.
Future Work
The preceding provides a possible playbook for project founders to implement Staking Options as a means of longer term value generation for their project and for users to better understand the incentives and potential benefits of participating in projects with SOs. As alluded to in Dual Finance’s whitepaper, expect Staking Options to become the market standard. No more will DeFi be an incesutous and exhaustive circle of free token rewards and simple yield farming.
Decentralized Finance will command more respect from institutions and retail alike as Staking Options incentives become prevalent and professionalize the industry. Just as big-tech Web2 companies do not typically issue their employees free shares but rather stock options for their compensation packages, so too should Web3 not give away free tokens, but rather Staking Options to its teams and network or participants. With Dual Finance at the center of its transformation, yield farming will evolve out of the impending dust bowl of nutrient depleting practices, to a moon laboratory of genetically modified super-crops — all from one simple innovation, Staking Options.
