The Non-Zero Sum Game of Crypto
Crypto is a zero sum game
Every trade you ever made was a zero sum game.
In the simplest terms this means there was a winner and there was a loser, with the winner’s gains being equal to the loser’s losses.
For example, if you sold a token at $100, and the next day its price rose to $120, you missed out on $20 over 1 day. The buyer, however, made $20 in the same time frame.
If you add the buyers gain (+$20) to the sellers loss (-$20) you get zero.
Hence, crypto trading is a zero sum game. Someone wins, and someone loses, and the amount the winner takes home is equal to the amount the loser could have had.
In this article, we are going to introduce a novel new protocol, Bumper, which protects the value of crypto from downside volatility, and one of the most interesting elements of Bumper is that it’s essentially a non-zero sum game of crypto.
Put Options: Also Zero Sum
Options markets are a great example of how trading is a zero sum game, and probably the best way to explain Bumper is to highlight its similarities and differences.
NB: We are referring to European Put Options as opposed to American Puts, with the chief difference being that European Put Options do not allow the option to be exercised prior to the expiry date.
Buying a Put Option is currently one of the widely used hedges against risk. If you need a refresher on what a Put Option is, you can read about them here, but the basic premise is it’s an agreement between two people who are ultimately betting against each other as to what the price of an asset will be at some point in the future. Like other forms of trading, this also results in a zero sum game, where the winner takes all, and the other side loses an equal amount of money.
One important factor relating to Options markets is that they are skewed in a one-sided manner, as the seller gets to set the price (the “premium”) which the buyer must pay up front. And the buyer has no idea how the seller has priced it.
Maybe the seller used a complex mathematical formula, such as Black Scholes, or perhaps they simply lobbed darts at a board to decide the premium. Either way, the buyer doesn’t know whether they are paying a fair premium or getting utterly ripped off.
Furthermore, there is always a threat of a level of counter-party risk when dealing with Options (in which a seller might not honour the agreement to deliver when the Option expires “in the money”).
Reimagining Hedging: Bumper’s price protection.
Bumper is a novel DeFi protocol which offers crypto price protection.
But Bumper is not an insurance contract. Nor is it a stop loss, or an Option. It’s something entirely different altogether.
Bumper takes the zero-sum ‘winner takes it all and the loser has to walk home with empty pockets’ kind of trading game and turns it on its head.
Because with Bumper, you end up with a non-zero sum situation, changing the game to one that minimises risk on both sides, is balanced and provably fair.
To understand how this can be, let’s first examine what Bumper is and how it works.
How Bumper works
In the Bumper protocol, there are two actors: Takers, who are buyers of protection, and Makers who provide liquidity.
Takers are users who wish to protect their crypto from downside volatility. They want to ride the rips, but get out when the price dips.
To open a position, the Taker selects a floor (similar to a strike price), a term length (an expiry date) and then they deposit their crypto on-chain into the Bumper protocol.
At the term expiry, there are two possible, mutually exclusive, outcomes:
1. The price of their deposited crypto has dropped below the floor
2. The price of their deposited crypto is above (or equal to) the floor.
It doesn’t matter if the price fell below the floor and then rebounded back up, then dropped below again, and so on. What matters is what the price was when the term expired and their position closed.
In the former instance, if the current spot price of their asset is below the floor, then they claim stablecoins equal to the floor value (minus the premium). This means they now have more value than they would have if they had done nothing and just hodled.
If the latter happened however, and the price is above the floor, they simply claim their original asset back. This means that if it ripped, well they haven’t lost out on the upside gains (as they would if they were to have used a stop loss on a trading platform).
In both cases, the Taker pays a premium in the asset currency when the term expires and the contract is closed.
On the other side, Makers are the liquidity providers who deposit stablecoins which are used to pay out Taker positions closing below the floor. Makers are able to determine their level of risk tolerance, and they also choose a timeframe for providing liquidity.
Makers are therefore accepting risk in return for generating a yield, which is derived from the premiums paid by the Takers.
So far so good… It looks a little like an Options desk. But this is where the similarity ends.
Non-combative pooled liquidity
Instead of a buyer purchasing a Put Option, where the terms are set by the seller, and which results in both sides taking a zero-sum position against one another (where one person wins and one who loses the same amount), in the Bumper protocol both Makers and Takers instead deposit their tokens into separate pools.
The unknown future — How Bumper calculates premiums
Now comes the fun and mind-blowing part.
In Bumper, the premium the Taker will pay comprises two parts: a smaller fixed element (essentially an operational fee) and a dynamic element.
Whilst the fixed element is known in advance, the dynamic element is not fully realised until the end of the term.
But, we hear you ask, how can you enter into an agreement when you don’t know how much premium you will pay?
This is the unique and novel difference between Bumper and pretty much every other financial instrument in both the crypto and tradFi world.
The dynamic premium part is determined by the actual volatility of the market during their term, with Bumper measuring the price each time there is a fixed period of price difference.
This means in a time of extreme volatility, with prices going up and down like crazy, the premium will be higher than if there was little or no fluctuation in the price.
In other words, even though neither Makers nor Takers know how volatile the market will be, both know there is more likelihood any individual Taker will make a claim against the Makers’ pool of stablecoins in the event of high volatility, and this is reflected in the premium levied on the Taker.
Instead of an individual Maker and Taker being engaged in a combative zero sum game, they are instead engaged in a game where risk is balanced between all the actors in the system who know that the smart contracts always calculate premiums in a provably fair manner.
Essentially there are two unknowns with an Option:
- what the forward volatility will be, and
- how the option was priced; but because the price is fixed, the buyer and seller have fundamentally agreed on what they believe the forward volatility will be.
Bumper flips the second point around, and thus the unknowns become:
- what the forward volatility will be, and
- what the premium will be, but as the method for calculating the premium is fixed / known, effectively each side has instead agreed on a fixed method for calculating a fair price based on the actual volatility as the input.
Comparing Put Options to Bumper
It is useful to go back and make a direct comparison between a Put Option and Bumper.
With Put Options:
- Neither the buyer nor the seller has any idea how volatile the market is going to be, but this has no bearing on the premium which is set and paid up front.
- You are directly competing against one another. One side will win, and the other will lose an equal amount.
- Both of you know the strike price and expiry date (which cannot be extended)
- Only the seller knows how the premium is calculated.
- The seller cannot roll over his trade, and thus needs to manage a portfolio of Options to diversify his risk, meaning Options selling is generally the domain of more sophisticated actors.
Now consider and compare the difference when using Bumper:
- Neither the Taker or the Maker has any idea how volatile the market is going to be, but both are fully aware the Taker’s premium will be based on the actual measured volatility during their protection term.
- Each side deposits and withdraws at a different time, with either side able to extend their term. Essentially Makers and Takers are not ‘matched’ against one another in direct competition.
- As premiums are calculated by the protocol’s smart contracts both Makers and Takers trust the smart contracts to be accurately and fairly enforced.
- Terms can be extended.
What this means for crypto enthusiasts is profound.
Bumper’s price protection protocol is provably fair and balanced, and more importantly, it creates a unique non-combative, non-zero sum environment for traders the likes of which has never been conceived before.
Bumper is an example of exactly what DeFi was meant to do — allow for novel and innovative products to be brought into the market in a decentralised and trustless manner.
To learn more, and get into more of the juicy details, including exactly how premiums are calculated and pools managed, we highly recommend reading the Bumper Litepaper
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