Introducing Divergence

Today, we officially introduce Divergence, a decentralized platform for volatility-based derivatives. This article summarizes our vision and offers a high-level introduction to our product.

TL;DR

1. Divergence provides a simple, yet effective, solution for users to trade and hedge their day-to-day DeFi-native volatility exposures. It offers liquidity providers low-friction access to earning volatility premiums as an alternative source of yield, in addition to the lending and liquidity farming yields they collect from other protocols.
2. Our first release is a specialized AMM-based marketplace for binary options written on a broad range of underlying asset prices, interest rates, and staking yields. Markets can be created at strike prices and expiration cycles of choice, using any fungible token — including DeFi assets issued by other protocols — in a one-step minting and seeding process.
3. At any given time, only one asset is required for liquidity provision. No over-collateralization is required for writing binary options. The trading experience is also akin to participating in a prediction market, with a deterministic payoff of one collateral or nothing from holding a binary option token to expiration.
4. Divergence tackles the market continuity problem by automatically rolling over pooled liquidity which reduces costs for liquidity providers to manage expiration issues in a smart contract environment. This is a crucial feature that enables continuous market price-discovery which will serve as a foundation for our next-stage products, i.e. volatility indices and index derivatives that provide opportunities for users to gain long and short exposures to on-chain tokenized volatility.
5. Designed to enhance composability, continuity, and capital efficiency of on-chain options markets, Divergence is positioned to empower other DeFi protocols by creating a financial risk-management and yield-enhancing layer on top of their existing value propositions to encourage adoption.

What Use Cases Are We Building For?

Consider an average liquidity farmer — Joe, who collateralizes ETH at Compound to borrow USDC, which he uses to provide liquidity to the USDC-WETH pool on Sushiswap to farm SUSHI. After he starts earning SUSHI, he restakes SUSHI for more rewards.

By now, farmer Joe has a lot of “skin in the game” when it comes to DeFi volatility — he is simultaneously exposed to multiple sources of risks that any liquidity farmer could face, including, but not limited to:

1. Unstable lending & borrowing rates of lending protocols. Today, most lending protocols offer variable interest rates, which are automatically adjusted relative to the supply and demand of any given asset pool.
2. Volatile staking rewards. Staking offers an additional income stream for token holders. While sounding “passive”, it is by no means fixed income. On the contrary, staking yields can be fairly volatile and are subject to many unpredictable factors.
3. Unpredictable asset price directions. Typically, liquidity providers on a DEX tend to suffer impermanent losses due to underlying asset price volatility, especially during periods of large market imbalances in one of the assets supplied as liquidity.

Despite the explosion of on-chain trading-related applications, there is a general lack of effective tools to simultaneously manage the multivariate risk exposures on the different layers of underlying DeFi assets today. More often than not, liquidity providers would have to give up part of their liquidity positions and/or allocate additional capital to hedge part of their risk exposures. In some cases, they would even have difficulty locating a compatible product to hedge.

Using the prior example — to ensure that he receives a steady income from staking SUSHI, our farmer Joe would first need to carefully calculate a hedge ratio for the amount of SUSHI he is about to receive. He then uses a portion of SUSHI and/or stable coin that he already has to establish a hedge position at a centralized exchange where meaningful SUSHI perpetuals/futures liquidity exists. In addition to the cost of this transaction, our farmer Joe would have to pay for the opportunity cost of unstaking this amount of SUSHI and/or stable coin, which he could have used to generate yield at an on-chain protocol.

(Note that we are talking about SUSHI, a DeFi bluechip with a reasonable amount of centralized exchange derivative liquidity. If Joe wants to manage the risk of a less established crypto asset, he may not even find a compatible derivative product in any venue).

Enter Divergence

Hedging DeFi-native risk exposures at Divergence is made easy by allowing for the use of any fungible assets as collateral to write and trade binary options at strike prices and expiration cycles of choice.

With Divergence, farmer Joe can now purchase an option using xSushi. Besides being a versatile hedging tool, Divergence also offers traders the opportunity to gain synthetic volatility exposure to decentralized assets that do not have commonly available derivative offerings. This also opens up a new category of yield for liquidity providers who will gain access to volatility premium, on top of existing lending and farming yields.

The Divergence Approach Towards Volatility

Divergence focuses on inclusiveness in building derivative products that harness the volatility of the ever-expanding decentralized asset universe. We set out to enable the dynamic creation of a plethora of derivatives that are based upon various financial exposures available in the market today.

Divergence Product Roadmaps

Binary options are key to this initiative for the following reasons:

1. Non-linear exposures. Unlike futures products, options provide a non-linear risk-reward structure, which allows option buyers to build leveraged positions in assets at a lower cost than making an outright transaction. It is possible to construct a portfolio of binary options composed of varying volatility exposures to different DeFi assets, many of which are not yet found in options markets on centralized exchanges.
2. Simple mechanism. Binary options have the desirable pricing mechanism that enables a predetermined constant number of tokens to be exchanged at expiration between buyers and sellers. In Divergence pools, the pay-off for a binary option token at expiry is either one collateral if the strike price is met, or zero, if not. The price of a binary call and a binary put is quoted in collateral units and will always add up to one collateral. This is considerably easier for retail users who may find it difficult to account for the risk-reward of plain vanilla options without the added complications of dealing with a decentralized protocol.
3. Building blocks for higher-order derivatives. A functioning options market shall reflect the market’s expectation for future price movements which is priced in its implied volatility. To be able to build a higher-order derivative product, i.e. VIX-equivalent volatility indices and index derivatives, it is necessary to obtain real-time pricing from decentralized options pools across a diverse number of strikes and maturities. While the smart contract environment is decidedly different when it comes to constructing a higher-order derivative, it remains imperative to allow for a price-discovery process by decentralized market participants which can then serve as a blockchain-native foundation for volatility index derivatives.

An AMM-Driven Synthetic Volatility Market

Our very first initiative is a user-friendly, immediately-scalable product that directly addresses the needs of users in the DeFi space:

an AMM-based marketplace that trades synthetic binary option tokens on the volatility of underlying assets.

These synthetic derivative tokens are created in a one-step minting and seeding process where peer-to-pool swaps occur. In legacy finance terms, when a stable coin is used as collateral, this is akin to writing a European-style cash-or-nothing option. In cases where an asset, such as LP tokens of DEX pools, is used as collateral, it is akin to a European-style asset-or-nothing option. At expiration, both types of option tokens offer a fixed payout of collateral — either in stable coins or in assets — when the strike price is met. Otherwise, they expire worthlessly.

The price of one binary call (“spear”) and one binary put (“shield”) is quoted in collateral units and will always add up to one collateral. This is hard-coded in the Divergence pricing bonding curve which is adapted from the Uniswap constant product formula. Trading these derivative tokens is similar to participating in a prediction market with a deterministic payoff of one collateral or nothing from one option token at expiration. This enables market participants to express a view on the probable outcomes of underlying price movements and market events.

What makes Divergence unique is that its design revolves around:

🏆Composability. Binary options markets on Divergence can be created using any fungible token as collateral on a broad range of underlying decentralized assets, including and not limited to:

1)Interest rates of specific lending markets, such as Aave, Compound, etc.

2)Staking rewards from different PoS assets.

3)Wrapped assets, decentralized stable coins, mid-to-long tail assets.

Just to name a few, it is possible to create and trade volatility markets for cUSDT/USDT (lending market assets), stETH/ETH (staking assets), WBTC/BTC (wrapped assets), or FEI/USDT (algorithmic stable coins) using their respective LP token, yield-bearing asset, or a stable coin.

How a DeFi user interact with Divergence Binary Options

Furthermore, because the protocol does not dictate which collateral is to be used for a particular underlying asset, it is also possible to create an exotic options market using assets other than stable coins, or the corresponding underlying asset. An example of this would be a binary option pool that bets on the price of BTC, using UNISWAP ETH/USDC LP tokens as collateral.

🏆Continuity. Divergence volatility markets, by default, auto-exercise positions and roll over the liquidity automatically upon expiration using identical terms. This ensures liquidity consistency and is very different from other protocols whose option tokens usually have a hard expiration and the market ceases to exist afterward without active management by liquidity providers.

🏆Capital Efficiency. It is inefficient for smaller liquidity providers to maintain the capital outlay across different strikes and expiries of options in a centralized order book environment, much less at an on-chain order book DEX. Liquidity providers on Divergence do not have to unwind the liquidity positions they already have on other protocols, as they can use LP tokens, or better still, borrowed capital, to create binary option pools. At any given time, only one collateral is required to write binary options and the same collateral is used in peer-to-pool swaps. The writing and buying of option tokens require no over-collateralization either.

How does it Work?

Two types of volatility markets can be created at Divergence: those that automatically roll over liquidity at a fixed strike price at expiration, and ones that rollover based on target volatility. In both types of markets, the expiration cycle and the collateral split to calls and puts set by the pool creator remain the same in a roll-over.

Target volatility is a fixed percentage calculated from the open price of a certain expiration cycle and is used to calculate an updated strike price for a new expiration. For example, a daily-settled volatility market created on 1 May 2021 5:00 UTC for ETH/USDC with +5% target volatility is technically set to open on 1 May 2021 00:00 UTC. The strike price for this cycle is calculated at 5% above the technical open price on 1 May 2021 00:00 UTC. During a rollover, the smart contract will recalculate a new strike that is 5% above the settlement price reached on 2 May 2021 00:00 UTC. It is also possible to create two-sided volatility markets using volatility targets of +/- 5%, versus the above one-sided market example.

The overall AMM mechanism is as follows:

1. One-step minting and seeding. At inception, liquidity providers can create volatility markets by committing collateral. The minting and funding of derivative tokens is one integrated process. Liquidity providers don’t need to separately mint derivative tokens (incurring gas fees), transfer them to another DEX (incurring gas fees), and then put up capital on the opposing side of the derivative offerings (incurring gas fees and requiring additional capital) to make a market. Instead, once an amount of collateral is committed, the same amount of binary option tokens are minted and funded to the pool. The pool creator sets the initial split of capital in making markets for calls and puts, strike prices, and expiration cycles. After prices drift from the initial offering, additional liquidity added to the pool is then auto-rebalanced to calls and puts market-making by the smart contract.
2. Peer-to-pool swap using the same collateral. When a trader deposits collateral into the pool to purchase a call, he or she adds to the collateral allocated to the call side. Based on the constant product formula on the call side, the trader can purchase Spear tokens at an updated call price. The put price is then updated to 1 minus the new call price. Correspondingly, the collateral, as well as the constant product on the put side, will also be updated. In the meantime, the smart contract will calculate the amount of collateral surplus added to the pool in addition to the liquidity provided prior to the transaction.
3. Automatic rolled-over liquidity. Managing liquidity continuity is tricky for derivative tokens with a finite time of existence. In the smart contract environment, an LP has to withdraw liquidity from the contract in use (incurring gas fees), mint derivative tokens on a new contract (incurring gas fees), and then fund liquidity into a pool again (incurring gas fees and requiring additional capital) for the market to continue to function. At Divergence, instead of creating new contracts for each option expiration cycle, only one contract will be utilized for one options market. As the option expiration cycle is continuously rolled over using a fixed strike price or target volatility, liquidity will remain in the pool until it is withdrawn.
4. Smart contract system as an ultimate liquidity provider. Before expiration, liquidity providers can withdraw their share of liquidity based on the condition that the maximum possible claim from the sold options against their collateral is being met and that an early withdrawal fee is paid. A number of option tokens will be burnt in proportion to their liquidity withdrawal. Because of this liquidity reserve for meeting the highest possible option claims, the smart contract system will remain as an ultimate LP even if all the LPs have withdrawn liquidity prior to expiration.

What to Expect in the Future?

Launching AMM-based binary options markets is just the beginning of our journey into the volatility universe of decentralized financial assets. The next steps for us include Ethereum L2 integration, which entails a number of possible trajectories as the Divergence product is designed to be blockchain agnostic. On top of this, we will concurrently develop a smart price quoting algorithm (“SPQA”) that adjusts for real-time volatility changes to help LPs dynamically update price quotes based on changes in market conditions. We also envision several paths for adding leverage to our smart contract system, thereby enabling “portfolio margin” for our liquidity providers and further enhancing capital efficiency.

Down the road, we aim to build a higher-order volatility index and index derivative which will derive live price feeds from our V1 option pools. These products will provide opportunities for users to gain long and short exposures to on-chain tokenized volatility. In our eyes, if in any way they resemble the index derivatives of the old world, they would likely evolve into a market of their own — A decentralized market of volatility.

Follow us

🔔Website: https://www.divergence-protocol.com/

💬Telegram: https://t.me/divergenceprotocol

🚀Twitter: https://twitter.com/divergencedefi

📢Telegram Announcement: https://t.me/divergenceannouncement