Respect the Tsunami-ishi: DeFi Option Vaults, Risk, and the IV League DAO
By: Monica Quantaince
One of the main reasons users explore DeFi projects is to find yield generation. Especially during the bear market, where liquidity is tighter, people are looking for stable, predictable places to put their tokens to make more money. DeFi Option Vaults (DOVs) are among the newer yield generating DeFi products, and at first glance DOVs seem like they are another form of yield farming.
It is critically important for users to realize that DOVs, however, are not yield farms–DOVs are the first iteration of a new kind of product, one that requires oversight but allows for powerful expression of a user’s opinions on the market. To explore the design space on better DeFi products that further evolve the current DOV design, we are creating the IV League DAO.
DOVs are Not Yield Farming
Users conflate DOVs with yield farms at their own peril. The primary hallmarks of a yield farms is that users can deposit their capital and then walk away with a minimal amount of management or oversight. Savvy users should not be fooled, though, and will recall the lessons taught by the tsunami-ishi, or tsunami stones.
Tsunami-ishi are Japanese high-water markers, carved in stone, that past generations left as reminders to future generations that, although many years can go by with no tsunami, eventually one will come, and anyone who has built a house below the tsunami-ishi will get swept away.
DOVs may seem like yield farms–Liquidity Providers (LPs) deposit capital and over a period of time receive a relatively stable constant return from the options sold by the vault. Some of those periods of time may even be quite long; a DOV can go months without having an event where a significant amount of the options sold expire in the money. However, eventually that event will occur, and LPs who didn’t anticipate the market and left their money in the vault will lose.
LPs can put their money into DOVs and experience great returns. Analogously, you can walk down to the beach, you can moor your boat there. But don’t build your house there, or park your capital and walk away. Eventually the vault will lose, and eventually the tsunami will come.
A Primer on DOVs
Options traders are experts at pricing the risk of rare events. Options contracts are a way for two parties to exchange a fixed upfront payment, the premium, for a delayed payoff based on some future fact (e.g. price of an asset). The fundamental value of options as a financial primitive is allowing market participants to express views on probabilities of events and transfer the consequence/risk of such events from buyer to seller in exchange for the premium.
Selling options can be lucrative if you believe the premium you receive overestimates the risk throughout the duration of an option–i.e. “No way ETH drops below $500 by next Friday” (not financial advice!). Multiple different DeFi Options Vaults (DOVs) are currently available to users, all of which can theoretically provide 20–30%+ yields by selling options to market makers.
Current DOVs function as follows: holders of tokens who want to earn yield deposit into the vaults and become LPs. Once a week, DOVs sell options contracts collateralized with the liquidity in the pool. At the end of the option term, if the options expire out of the money, the DOV pool keeps the option premiums and distributes returns to LPs. If the options expire in the money, market makers earn the difference between the strike and current trading price, potentially resulting in a loss for LPs.
Using DOVs Wisely
If the market prices options correctly on average, then we should infer that the expected long-term yield from passively buying or selling options should be zero. Meanwhile, a highly-active LP could in theory outperform by depositing and withdrawing at the right times. With the simple strategies that underpin current DOVs, a passive set-and-forget LP could expect to only break even over the long term.
When LPs don’t educate themselves on mechanics of options and set-and-forget their capital, they’re building their house below the tsunami-ishi and assuming the yield they’re getting is risk free. The tsunami comes when vaults lose a portion of their assets because of a massive market event.
We have researched the performance of popular DOV strategies under various market conditions and come to interesting conclusions. While current DOV strategies lack the properties to qualify them as stable investment products for passive LPs, they are still powerful tools that laying a foundation for a decentralized ecosystem for directional risk trading.
In these early days of the very first DeFi products, we ask what products and strategies should exist to provide sustainable yields for LPs? And what kinds of products should be built to give users even more control over how to use DOVs, and other tools, wisely? The design space is truly large, and we’re starting to explore.
Introducing IV League DAO
In order to continue this work, we are creating the IV League DAO, a community of DeFi users focused on better understanding implied volatility, derivatives, and ideating on DeFi products that will support the crypto market at large. We will design and stress-test automated options strategies that offer sustainable returns for liquidity providers. This research, methodology, backtesting, and simulation code is the founding contribution to the IV League DAO.
The IV League DAO currently includes community members of the Siren project–a composable DeFi option protocol–who were vital in our research and have offered a vault in which the IV League DAO can build option strategies and iterate quickly. Our community will drive innovation in the DeFi options space and invest the DAO holdings into new, cutting edge strategies to create value for our members and DeFi as a whole.
For the time being, as we build this community, we’re keeping it small. We believe the greatest value we can add in these early days will come from a team of strong collaborators. So we’re opening up the admissions process to a select few. We have certain roles and values we are looking for from this early community, join the team, applications will be open until Friday, August 5th. We will be reaching out to conduct 1v1s from August 5th-19th.
We are looking forward to building with you!
IV League DAO
