An Avalanche of DeFi: Arrow Markets
Just because there is an apparent gap in the Avalanche DeFi ecosystem, does not mean that just anybody can fill it, or even that it needs to be filled. Of course, the opposite is also true. Just because there are already competitors in a space does not mean that a new competitor can’t win.
We at Aventures are looking for teams that have the capacity and knowledge to set them themselves apart from any competition, current or future. As Avalanche OGs and active community members, we add support as a service in addition to our funding.
In Part II I covered Dexalot, who will profit from its layer 1’s fast finality to bring order book market making and fair launches to Avalanche. While they are certainly filling a niche, it’s the team and the technology that impress us. They also have the community. But, if they didn’t, we could help with that as well.
This week I’ll be presenting several of our other core DeFi investments, Struct and Pollen, as well as two protocols we are very excited about: Valk and Arrow. Each addresses a niche that was previously empty.
2. Arrow Markets — Options without the middleman
A call option is the right but not the obligation to buy a fixed amount of an underlying asset at a fixed price (the “strike”) over a pre-determined time horizon (up to or at “expiry”). A put option is a right to sell the underlying. There is evidence of active trading of both in the 17th century, though they may originate earlier than this.
It wasn’t until the Black-Scholes-Merton model circulated in the 1970s that traders felt confident enough to make prices on any option on any liquid underlying. That confidence turned out to be misplaced, and workarounds were invented after the Crash of 1987.
Options allow speculators to add downside-protected leverage to a long market direction position, by buying a put when bearish or buying a call when bullish. On the other hand, options sellers (writers) can earn income by taking the other side.
The TradFi options markets are enormous. On the largest exchange, the Cboe, Apple options on 441 million shares traded in December 2021 alone. This doesn’t take into account the over-the-counter (OTC = non-exchange traded) options markets, which are even larger. OTC options on swaps, for example, traded more than $1 trillion in notional in Q1 2021.
As crypto natives tend to be very interested in leveraged speculation as well as in earning yield, options seem a perfect product for DeFi in general, and Avalanche currently hasn’t any native alternative. Arrow markets plans to be the first native options protocol on the Avalanche blockchain.
Paradigm, an OTC desk, currently dominates crypto options trading, executing $9 billion last month, primarily through the centralized Deribit exchange. BTC options alone on Deribit accounted for $400 million in volume on an average day last month.
Decentralized alternatives have also been gaining momentum, especially where they form the primitives on which structured product and strategies are based. Ribbon Finance and StakeDAO, for example, execute their automated strategies using the Opyn option DEX.
Options on Ethereum and Solana are indeed growing quickly, and the market gets more competitive with each new entrant.
Activity of Avalanche so far has been limited to a few of the largest cross-chain competitors, with no native protocols launched to date. That’s where Arrow Markets comes in.
Compared to TradFi, and even to the dominant centralized exchange Deribit, decentralized options protocol traction has been somewhat disappointing. Two days of Deribit volume exceeds the entire TVL in the decentralized space. Arrow Markets aims to overcome the many headwinds by deploying on Avalanche, using an Automated Market Maker (AMM), and developing a novel pricing and risk management mechanism.
Automated Market Maker for options, for maximum flexibility
The first main issue with many options platforms is they rely on order matching (through a request for quote (RFQ) or order book). For a user to trade on Opyn or Friktion, another user with an opposite need must be found, or a professional market maker must step in. Other protocols, such as Dopex and Thetanuts, rely on option selling vaults for liquidity for option buyers, limiting the flexibility the platform can offer to traders.
Arrow, along with Hegic and Zeta, uses an automated market maker to provide flexibility to option buyers and sellers alike. Arrow’s AMM can provide liquidity for any option, so that any derivative on an underlying asset can theoretically be traded on the Arrow platform. There will be no need to find a matching buyer for every seller and vice versa.
Any new option is valued with a utility-based indifference pricing engine. These complicated calculations are done off chain, but it is a priority on Arrow’s roadmap to bring them in some way, perhaps using a subnet with a custom VM.
If the trader wishes to execute at a price quoted by Arrow’s AMM, the trade is added to the pool, and any residual risk to the underlying asset is “delta” hedged by buying or selling in the spot markets. The AMM therefore allows buyers and sellers to act without any market makers or any other gatekeeping and fee-taking middlemen.
Decentralized options are generally extremely capital inefficient. While option buyers only need to pay the (relatively small) premium upfront, options sellers usually need to be fully collateralized for any future liability they may have. In the case of selling call options, that obligation is technically unlimited. Arrow will be one of the few protocols to allow for partial collateralization. An insurance fund steps in if the collateral for each underlying asset is not enough to pay off all obligations.
Complexity hidden from the UX
Arrow’s Testnet reveals a very elegant UX that shields the user from the complex calculations and market transactions occurring behind the scenes. Options strategies are recommended based on simple parameters. The optimal position, according to Arrow’s Testnet, for a speculator that believes AVAX will rise 10% within 2 months is a 2 month call option with a strike price of $76. No need to understand the complicated option “greeks” or option pricing theory at all.
The market for options in TradFi is huge relative to the size of the spot markets. Deribit’s success in ETH and BTC proves that options on crypto assets are also popular. Centralized options risk the ire of regulators, however. Americans, Japanese, Koreans and residents of Canada’s most popular province cannot use Deribit. Europe, so far, has not cracked down on crypto options., though regulatory action is on the horizon. Decentralized derivatives may offer a solution, for now.
Avalanche currently has almost no options volume, and even the top DeFi protocols have limitations. We believe Arrow Markets could become the dominant decentralized options platform, on Avalanche and beyond.
Rasheed Saleuddin, PhD CFA is an ex-hedge fund manager and experienced crypto angel, currently investing and advising with AventuresDAO, TheBoringDAO and the Cosmic Cartel. He is also a researcher at the University of Cambridge Judge Business School, where he is co-chair of the Cambridge Centre for Alternative Finance (CCAF) DeFi research steering committee.
AVentures is an investment DAO composed of OG Avalanche community members on a mission to support the ecosystem. The team boasts multiple successful blockchain developers and project owners, content creators, advisors and domain experts that have come together to channel our expertise to support the Avalanche ecosystem.