As Options turns 50, is it time for hedging risk to get an update?

“Time destroys the speculation of men, but it confirms nature” 
Marcus Tullius Cicero (106 BC - 43 BC).

Speculating on future events to derive profit isn’t a modern idea. Possibly the first Options trade in history is accredited to the ancient Greek philosopher Thales somewhere around the 6th Century BC.

The story, published in Aristotle’s key work ‘Politics’, centres around Thale’s bet on an abundant Olive crop the following summer, in which he paid an advance ‘premium’ to secure the ‘option’ to use the towns Olive presses at a fixed price. He then turned a healthy profit by selling these rights to the local farmers at an elevated price following an unusually bountiful harvest.

Fast-forward to the Dutch Tulip mania of the seventeenth century, and the concept of Options trading once again exploded with ordinary people YOLO’ing their entire life savings to secure the rights to future tulip harvests. The mania eventually collapsed in 1637, when buyers announced they could not pay the exorbitant prices previously agreed upon for bulbs.

Then, in the late 19th Century, American businessman Russell Sage developed the first modern examples of Call and Put options, although these lacked the standardised terms we are familiar with today, and were very much a niche product with limited appeal.

In fact, despite its long history, it wasn’t until 1973 that Options went mainstream with the establishment of the Chicago Board Options Exchange (CBOE) which still remains today arguably the largest US equities market operator.

The advent of digital trading has seen an explosion in Options trading, with 2021 setting a new record for the volume of money routing through Options desks.

And yet, despite a number of seismic shifts in the financial markets over the last half-century, there’s been scant innovation surrounding Options markets in the subsequent decades.

Today, financial markets have never looked so ripe for fundamental change. After decades of money printers going “brrrr” (especially in the last couple of years), governments and Central Banks are scrambling to control inflation as the global financial system teeters on the brink of a major collapse. Panic and mania are back with a vengeance.

And of course, the innovation of Crypto has changed everything. Not just in terms of how we deal with transactions and payments, but in the very nature in how society is shifting, and decentralisation is now a mainstream concept.

Crypto has made it possible to develop financial products that exist outside of the existing system. Over a relatively short timespan, DeFi products have emerged to challenge the status quo, so long enjoyed by Wall Street and the banking elites.

As the modern Options exchange celebrates its half-century anniversary relatively unchanged, perhaps it’s time for new and novel solutions to enter the 21st Century’s financial Zeitgeist — including a fresh approach to risk-market speculation.

Outdated characteristics of Put Options as a hedge

There are some interesting characteristics inherent in Put options, which are widely used in traditional finance as a hedge against downside price action.

Firstly, Options are inherently an adversarial, zero-sum game between two individuals — one will win, taking all the profit, whereas the other will lose an equal amount. Thus, each side must either have conviction that their thesis is the correct one, or they believe that the premium represents a good value for the risk-reward.

However, it’s the seller who alone sets the price for the contract, and the buyer is left to determine whether this cost represents good value without knowing the methodology by which the seller came to determine the price. This favours the seller, as they are able to factor losses into the price if they so choose, and there is nothing the buyer can do about that (other than refusing the contract).

But more importantly, as Options desks don’t require users to purchase a single token, Put Options are effectively a gamble on price action, but they don’t actually protect the value of discreet tokens held in a users wallet.

We set out to address this problem. And we not only found the answer, but we’re actually building it.

Volatility drives crypto aversion

The old financial world-order looks to be collapsing. Inflation is at decades-old highs, Governments are planning their own programmatic CBDC’s, and even strategists from huge Banking corporations are starting to view crypto as a safe haven (or at the very least a hedge against hyperinflation). So why has there not been an even bigger rush towards crypto mass adoption?

The narrative over the last couple of years has switched from “crypto is only used by criminals” (fiat currencies have never been involved in crimes, right?), to even mainstream press outlets talking about Bitcoin’s wild gains… and in true MSM fashion, authoring clickbaity articles on the “death of crypto” every time there’s a move lower.

Crypto OG’s, comfortable with the highly volatile nature of crypto aren’t shaken by a bit of downside action, but the same cannot be said for those who are eyeing crypto for the first time.

Thus, volatility remains one of the biggest blockers keeping Joe Normal from deciding to divest from traditional, centralised finance, into cryptocurrencies. The psychological impact of potential losses for many outweighs the benefits of being their own bank and sidestepping the often corrupt world of TradFi.

But it’s not limited to noobs. Even the most battle-tested crypto-bro wants to limit risk, or otherwise Stop losses and Options just wouldn’t even be a “thing”.

So, can DeFi solve for Volatility or are the wild swings we regularly see in cryptocurrency markets simply an inherent feature (and a bug) of an unregulated and permissionless asset class?

More importantly, do crypto users want to see the end of all volatility? The answer is likely a resounding no… because without volatility, there really aren’t the opportunities for massive gains. It’s the losses we don’t like. So perhaps it’s more accurate to ask if there is a way to solve against downside volatility, whilst retaining the upside? Now, that is a question!

Can DeFi solve for downside volatility?

In the last couple of years, we’ve witnessed the emergence of a range of tools that replicate those available in the TradFi world, including borrowing and lending using crypto holdings as collateral and indeed new decentralised variants of Options desks.

This is all very well, but from its inception, DeFi seemed to promise so much, including new “primitives”, or building blocks on which newly imagined products and services can be realised.

For sure, there have been some (Flash loans are a great example), but it’s surprising that there haven’t been more concerted efforts to solve for the volatility problem.

There are also a few interesting risk markets out there in the DeFi space, and some have done a great job at simplifying hedging, but they are essentially Web3 clones of already existing financial instruments, including insurance products, Options desks and Futures markets.

Settlement in crypto and tracking the prices of a particular asset class is one thing, but holding the value of a discreet token is quite another.

Enter Bumper — A completely unique risk market with the potential to completely change the hedging game forever, with a new kind of DeFi primitive.

Solving the problem of downside volatility

When we set out to come up with a way to deal with the problem of rampant volatility, we realised why it’s a problem that hasn’t yet been solved — it’s actually ultra-complex. Essentially, we needed to come up with a way of holding value in any and all economic conditions, shifting risk from fee-paying protection seekers to yield-seeking liquidity providers, and balancing risk to reward to ensure it was capable of attracting sufficient liquidity to function.

This in itself is no different to how Put Options work, but we were keen to apply this to user-held tokens, as well as ensuring there was still some level of composability to the protected tokens.

That said, humans are ingenious when presented with a problem, and the solution we came up with has, over the fullness of time, grown arms and legs, and has turned into an exercise in building a team of highly capable wrinkle-brained engineers, strategists and thinkers.

There are a number of key elements which, when combined, create a product which solves for downside volatility — not inherently across the whole market, but certainly for the individual user.

Here are some of the elements which Bumper incorporates which, together, solve for downside volatility, whilst preserving the upside:

• PEER-TO-POOL DESIGN

The protocol defines a two-sided market into which users lock their tokens — protection buyers deposit crypto assets, and liquidity providers deposit stablecoins — into separate pools.

Rather than participants taking an opposing position to one another, all interactions are between users and pools, rather than users directly, and they rely on users on either side holding actual tokens, not simply placing bets on price action.

• FLOOR & TERM SELECTION

Using Bumper, Protection buyers select a floor (akin to a strike price) and a term length (similar to an expiration date). Should the price of their asset at expiration close below their chosen floor, then they exit with either stablecoins at the floor value, or by taking their original asset plus the difference in value to the floor made up in stablecoins.

But should it close equal to, or above the floor, they simply retrieve their original tokens and exit. It doesn’t matter whether, or indeed how often, the price drops below the floor and then rebounds, because Token swapping does not take place at any point during the term (thus, no parasitic costs such as slippage or fees are incurred).

• INCREMENTAL, EX-POST-FACTO PREMIUMS

Bumper takes the idea of premium payments — the cost of protection — and does something completely different to pretty much every other financial instrument out there — it calculates premiums incrementally when the protocol’s state changes (for example when volatility increases).

In other words, rather than basing the cost of protection on the implied volatility measured from historical price action data, the protocol instead applies premiums based on actually how volatile the market gets whilst a user's position is open.

So, for example, when the price of a protected asset is in a steady and tight range, premiums are low and infrequently applied. Conversely, when market volatility picks up, (especially to the downside), premiums, and regularity, increase.

Furthermore, premiums are deducted from the entire protection buyers' pool of locked assets, not individual positions. This means that the actual premium paid by an individual user is, for all intents and purposes, settled retrospectively (ex-post-facto) when the position is closed.

Whilst the actual premium to be paid is not known (unlike in a Put Option), the methodology for the calculation of premiums is effectively agreed upon by users on all sides prior to opening a position, mimicking a form of “original position” proposed by the American philosopher and economist John Rawls in his ‘Theory of Justice’.

• YIELD EARNING MECHANISM

Premiums of course form the basis of yield for liquidity providers, who are incentivised to deposit stablecoins with the potential for earning yield in exchange for assuming some of the downside risk.

But this is not the only way that Bumper generates yield for depositors. Because term expiry is known, there will, under normal operating conditions, be an amount of locked assets which are not required immediately to meet outstanding liabilities when users close their positions at the end of their term.

This allows Bumper to use these “temporarily surplus” assets to engage in liquidity mining, earning an additional yield which is distributed to the user pools to both increase yield potential and reduce the cost of premiums further.

For stablecoin holders, therefore, depositing into Bumper is highly attractive due to having more than one mechanism for deriving yield.

• BONDED UTILITY TOKEN

Bumper’s native ERC-20 token, the imaginatively titled BUMP, is vital in regulating order book flow. There needs to be a method of ensuring sufficient liquidity is always available, and this is made possible through the limited supply of BUMP tokens.

Users on both sides need to hold BUMP tokens in their connected wallet in order to participate in the protocol, a process called Bonding. This has the net effect of reducing spikes in inflows and outflows disruption the operation of the system.

BUMP tokens are also used to further incentivise users on both sides to open positions should there be some imbalance measured on one side or the other.

• BUMPERED ASSETS

When protection buyers lock in their crypto assets, they are returned a composable “Bumpered asset”, which effectively represents the protected asset and, thanks to the guaranteed floor price, it maintains a minimal price level.

Bumpered assets open a range of interesting possibilities for improved capital efficiency and risk management, Bumpered asset tokens which are issued back to users are freely composable into other use cases and their protocols, such as a replacement for collateral in lending, or liquidation protection in leveraged trading.

Thus, Bumpered assets function as a wholly new DeFi primitive, a token which represents a synthetic but fully collateralised position, and which has its downside volatility removed. Utter genius!

Conclusion

Options may well have been around since the dawn of civilization (or thereabouts), but DeFi is changing the way that we think about hedging risk.

The profundity of a simple-to-use protocol which directly applies downside volatility protection whilst simultaneously retaining its composability, cannot be underestimated.

Bumper’s mission is to provide a simple, price-efficient crypto risk management tool with a number of additional features that make it highly attractive to a wide gamut of crypto enthusiasts, from absolute beginners to hardcore degens, professional traders and fund managers.

This, we believe, will encourage wider adoption of cryptocurrency, as even new users have the opportunity to gain protection over their crypto assets right from the outset.

For a user of the Bumper, creating a protection position is extremely simple (unlike deciphering Options contracts), and doesn’t require constant monitoring for rebuy decisions (unlike a stop-loss).

Bumper eliminates the threat of counterparty risk and uses only natively available on-chain information to define a non-zero-sum game between market participants who hold different perspectives on price outlook. Furthermore, it lets users access other DeFi financial products whilst still retaining protection from the downside.

While such features may not appeal to certain traders who prefer to engage in zero-sum competition against other traders, Bumper is designed for those users who wish to protect against price risk with minimal effort, and minimise (or eliminate altogether) liquidation risks and impermanent losses.

Learn More

Want to learn more about Bumper and how we’re solving the problem of downside volatility? We recommend reading out Litepaper or super-simple Flashpaper to get a good handle on exactly how Bumper works.

Alternatively, drop into our Discord server and join in with the community (and feel free to ask questions too!)

Disclaimer: Any information provided on this website/publication is for general information purposes only, and does not constitute investment advice, financial advice, trading advice, recommendations, or any form of solicitation. No reliance can be placed on any information, content, or material stated on this website/publication. Accordingly, you must verify all information independently before utilising the Bumper protocol, and all decisions based on any information are your sole responsibility, and we shall have no liability for such decisions. Conduct your own due diligence and consult your financial advisor before making any investment decisions. Visit our website for full terms and conditions.