Asteria Essentials #12 - Decentralized Options Vaults (DOVs)

👋Hello Asterians,

We’re proud to formally announce that we will be adding a new feature to the Asteria architecture soon: Asteria’s Option Vaults.

Before we divulge the details of the product itself, let’s set the stage first. Asteria Option Vaults belong to a very special class of crypto structure products called Decentralized options vaults or DOVs.

In this blog post, we’ll talk about the specifics of DOVs, their value propositions, and a primer on Asteria options vaults. Subsequently, in the next post, we will introduce the product itself.

The Obligatory Introduction

DeFi options saw phenomenal growth in 2021, marked by an exponential TVL growth of

$92 million in the second half of 2021, to over a billion dollars in May 2022. Besides the inherent novelty and efficacy of DeFi options strategies, slow adoption has enforced a great foundation for its steady growth.

The overall on-chain options ecosystem in DeFi largely comprises of two layers — marketplaces and structured products. Marketplaces create option contracts and enable their buying/selling. Structured products are then built on top of these marketplaces, offering automated option strategies packed in modular vehicles –DOVs.

What are DOVs?

DOVs were introduced to the market in early 2021; before their launch, option strategies were only accessible to sophisticated investors/buyers either via :

  • OTC (over-the-counter) trading, or
  • Manual means on options exchanges

So the first utility that DOVs unlock — accessibility — to complex, high yield-bearing strategies.

The second utility it unlocks — simplicity for non-accredited users…

…in no particular order, each utility fuelling the other.

Mostly, plain vanilla options, including — covered calls and cash-covered puts strategies. On a side note, the current architecture of DOVs limits them to plain vanilla options. Asteria is building a new suite of options vaults that can support more complex options structures.

What makes DOVs different from typical vaults in DeFi?

The primary source of yield in DeFi is a lending/borrowing wheel. So some channels of yield farming would include:

  • Moving across a low-risk lending pool to a high-risk one for capturing more yields i.e, exchanging risk
  • Executing different trading strategies i.e arbitrage

In other words, yield in DeFi is critically dependent on protocol token distributions.

Why is that a problem?

Consider the following scenarios:

  • Adverse market conditions could cause excessive liquidations. Such events could stir speculators to sell the asset on a massive scale;
  • Macro market panic of any sort, including technical risks, in general, associated with smart contracts;
  • Lastly, participants chasing higher profits will go after other higher-yielding venues, triggering a downward spiral of lowered liquidity and the asset’s valuation.

What can we take away from these scenarios?

  • Yield dependent on token price inflation is synthetic and cyclical;
  • Yield can easily flatten out following any potential movement within the macro market;
  • As pool participation increases, it results in a crowding effect — less LPs in a pool, higher yield, more LPs in a pool, and lesser APY.

To that end, it would be interesting to see how the mechanics of yield farming establish a mid-to-long-term equilibrium and if it would still be attractive to users with a bigger reward appetite in the long run.

Unlike traditional vaults, DOVs don’t rely on token price inflation/rewards; instead, they leverage the underlying asset’s high implied volatility. The yield generated is then deployed into DeFi via option premiums.

DOVs are a paradigm shift from the imploding layers of token creation and distribution towards a real value collection based on the base market structure and trade volatility. As such, by moving away from cyclicality, they solve the puzzle of long-term sustainable yields.

Moreover, risk management is executed off-chain since investment, price discovery, settlement, and collateral are managed on-chain. In this case, yield generation is straightforward, which lends even more transparency to the whole process.

Last but not least, DOVs have been the biggest proponent of the altcoin option market. With the advent of DOVs, the market no longer remains limited to ETH and BTC options. When earlier options besides ETH and BTC remained largely illiquid, DOVs became the avenue and primary source of liquidity for Altcoins, giving token holders even more channels to generate higher returns. But that’s just the end of the beginning — of new possibilities — institutional possibilities. As both large-scale and small-scale investors see more value in DOVs, coin flows have only gotten larger since.

The New Age of DOVs? Missing pieces?

Asteria is building on-chain vaults consisting of automated options strategies. But that is not what makes the product special. Existing option vaults, including Ribbon and Dopex, have specific flaws baked into their design — deposits come first, followed by buying of calls after a limited amount of base asset.

This prevents investors from manually hedging their positions and enhances the chances of pumps on the base assets. Moreover, impermanent loss hedging on such vaults comes from buying call options that offset IL, adding a portion of the fees to users’ staked principal. This mechanism could be considered similar to Bancor’s recent impermanent loss fiasco. Superficial hedging does not offset the risk and simply makes it invisible.

The investor is still exposed to the underlying asset price downtrend, which is partially reduced by the option premium. In cases where the price of the underlying asset skyrocket, the investor’s USD PNL remains capped. This means the investor would have incurred an opportunity cost just holding the asset.

So what if we could still get the efficiency of DOVs, but with quantitative risk management and dynamic hedging baked into its design? With Asteria’s options vaults, that is exactly what we’re doing. These dynamic implementations will unlock unprecedented quality of base yields and enable more active participation from both seller and buyer sides.

More on the how’s and why’s of Asteria Vaults in the upcoming blog posts! Stay tuned!

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Asteria

Asteria, committed to be DeFi infrastructure, defines decentralized protocol of option pricing, trading and hedging of AMM mechanism