Optimizing Auction Execution
Welcome to Sparks, Friktion’s DAO contributor driven Quantitative Research insights on market structure, trading, and Volt design written by Friktion Research Collaborators. Previous articles here and here for background.
Learn more about Friktion @ https://friktion.fi
Options execution challenge
We’re excited to share the results of a research problem we’ve been investigating amongst Friktion Research Collaborators and Inductors.
The popularity of DeFi Option Volts (DOVs) has increased quickly in recent months. Friktion alone has amassed over $100m in TVL in just a month of being on Solana Mainnet Beta. There has been a lot of publicity around the effects of DOVs on volatility term structure. Implied volatility has been compressed to the lowest we’ve seen in over a year in part due to structural volatility selling by DOVs (5–15 delta region).
Term structure (shape of the implied volatility curve over time) has steepened due to DOVs and market participants systematically selling shorter term expiries as a form of yield generation.
If looking to firm your understanding of options — read a primer on Institutional Options Trading.
Shorter dated out of the money (OTM) options are drifting cheaper due to an imbalance of weekly sellers from vaults and from external market participants anticipating this flow and preemptively selling before vault auctions. As Open Interest (OI) grows and diversity of participants matures, expect this effect to remain pronounced. Inductors have built Volts as structured capital allocation strategies for specific market environments, but as in any rational long-term market, any single source of yield is finite. In the end, protocols like Friktion with the the tools (dynamic risk and liquidity models) and agility to react to market dynamics will capture more yield for users.
Market impact of Volt strategies
How does Friktion’s auction transact $100M+ of options flow weekly and minimize its price impact? For some context, here’s the meta:
- Deribit, the largest centralized options exchange, manages the largest weekly options expire every Friday at 8am UTC. Options vaults typically hold their auction to sell their options this time as well, with expiries lining up with the Deribit expiry. This makes it easy for market makers to deal with the flow they get from DOVs. Since it’s operationally easier to handle, they can offer better pricing and more yield to the vaults. Right now, every single vault has its auction within 2–5 hours after Deribit expiry. Many other market participants like crypto hedge funds looking for yield will typically sell weekly options during this time. What happens when >$500m+ of options are sold across venues at the same target delta region at the same expiry at the same time every week? An efficient market should price in this structural flow.
To highlight this effect, examine volatility dynamics in the market around the weekly expiry using a dataset beginning in May 2021. On average, the 1-week expiry 10 delta BTC call fell 2 vol points leading up the expiry before recovering 12 hours afterwards.
The difference for ETH calls is even greater. On average, 1-week expiry 10 delta ETH calls fell 3–4 vol points on average leading up the expiry before recovering 12+ hours afterwards.
During a recent expiry (January 21, 2022) an especially egregious pricing event for DOVs was observed with IV dampening by >15 vol points before auctions began with it recovering by 15 points afterwards. This resulted in vaults selling at a much lower IV (collecting less premium) in a volatile market environment.
With IV ~58 at expiry, a 15 vol point difference for a 10delta call would imply yields shifting up from 21% to 52% APY. A huge and unacceptable difference!
Volt Strategy Changes
How should Friktion adjust Volt strategies to avoid this observed effect? The analysis indicates Friktion should conduct Channel RFQ options auctions either T-6 or T+12 hours from Deribit expiry to take advantage of naturally higher IV conditions. There are a few complexities with moving auction time:
- If the expiry doesn’t line up with Deribit, market makers have to pay more to hedge the position. This eats into the pricing they can give and potentially reduces end-user yields.
- If the expiry lines up with Deribit expiry, but starts 12 hours after, then 12 hours of theta are lost(time value on option).
- As with most strategies, it’s natural to expect other market participants to follow behind. Friktion Volts handle the most structural SOL and BTC options flow across DOVs platform today — as more Volts are added expect a novel way to reduce off-chain market maker dependence while not compromising on execution or pricing.
An Altcoin Strategy
Part of what makes Friktion exciting to research is that more than 70% of the TVL in Friktion’s protocol is concentrated in non-BTC/ETH tokens (we will naively refer to as altcoins), which don’t currently have CEX listed options. Because there is no off-chain equivalent, Friktion has an extremely wide expiry selection space. This is quite exciting from a mechanism design perspective and plan for a follow up piece on how this can use this to create a new method of token issuance.
Given most crypto volatility MMs/arbitrageurs typically price these altcoins against ETH, the effects of holding alt-coin auctions earlier when ETH volatility is systemically higher will result in even more yield for Friktion Volts! Upon backtesting weekly Volts Historically traded IV against ETH 10delta 7dte IV, one can observe that auctions would receive better prices if brought-forward by 6 hours.
That’s pretty juicy!
BTC/ETH Strategy
Since the dominant naturally competitive marketplaces for BTC/ETH exist off-chain (for now), an expiry optimization process for the liquid Volts requires a little more nuance. There are some complexities to doing so prior to the existing high liquidity expiries:
- Having MMs largely preempt flow on these expiries eats into fair pricing across time. Those hedging BTC/ETH options on Deribit options/futures/perps that may expire at a similar window. If options expired 6 hours earlier, they would have to unwind their hedges instead of holding it into expiry, adding additional cost. It’s unclear if 2–4 extra vol points of yield is worth the decrease in yield from extra hedging.
- Friktion BTC and SOL Volts represent the largest option contracts Open Interest across every blockchain (OI = number of outstanding contracts in the market). Adjusting options expiration times will cause a similar impact to (3) and the market prices in the timing adjustment which reduces the efficacy of having the auction earlier.
The other alternative is to sell the BTC/ETH options 12 hours later, at 20:00 UTC. The downside is again 12 hours of lost theta. Recall the January 21, 2022 scenario re-illustrated below:
Impacts of delaying auction > T+12hrs: losing 12 hours of theta and 3 vol. The worst of both worlds — as observed on January 14, 2021:
The value of 12 hours of theta can be understood as a function of implied volatility is, per the roughly 3.5% APY.
Historically, has it been +EV to move all auctions back? Does the increase in implied volatility make up for the decrease in time value is collected?
What does a backtest consistently selling 10 delta strike at the implied vol for each hour after the auction (adjusted for a decrease in time value) look like?
The below plots show historical yields by week of moving the auction back 0 to 14 hours (which each line representing the cumulative yield of moving the auction back x hours) subtracted by the baseline (doing the auction exactly at Deribit expiry). For example, the blue line corresponding to 0 is always 0 because it is normalized. The orange line corresponding to 1 is the cumulative difference of yield by moving the auction 1 hour back and the baseline. Notice how no lines end up positive. This means that naively moving auctions back doesn’t make up for the loss in time value for all time periods.
So moving all auctions back doesn’t make up for the loss in time value. Notice however, that during certain weeks, it is very much worth it to move the auction.
Can these weeks be predicted ahead of time and priced in accordingly?
One such signal is market implied volatility vs. realized volatility. One such backtested scenario is when RV >> IV, avoid selling since the probability of being fairly compensated for the volatility is low.
Though the data is dominated by a few outliers, the signal can help us prevent catastrophic weeks like in January 21 where fair value is violated.
This investigation indicates an optimal strategy is to hold auction at normal times immediately after Deribit expiry. If observed that auction participants are offering prices at IV levels below 24 hour RV, then delay the auction until implied volatility is closer to RV.
Conclusion
Based on data evaluated, by moving altcoin auctions 6 hours earlier, Friktion will take advantage of structurally higher implied volatilities and help define the volatility surface of on-chain options. Research recommends keeping BTC/ETH at the normal expiry time while retaining the ability to adjust it 12 hours back during regimes where implied volatility is meaningfully below realized volatility.
These Volt design optimizations will capitalize on volatility market dynamics enabling higher risk-adjusted returns for users. While over time other protocols will naturally adapt accordingly, Friktion Inductors and Research Collaborators believe these steps are positive sum for the DeFi derivatives entire ecosystem growth.
The focus remains leveraging a deep understanding of markets and quantitative trading with agility in reacting to a variety market conditions to maintain the highest risk-adjusted returns across DeFi for Friktion users.
Interested in contributing to the Friktion quantitative research and strategy effort? Join one of our Taskforces and let’s build the future of finance together.
Website: friktion.fi
Twitter: @friktion_labs
Discord: discord.gg/friktion
Medium: friktionlabs.medium.com
Documentation: docs.friktion.fi
Shoutouts to our friends at Genesis Volatility and Deribit Insights for their contributions to the research. Please check them out below
