Decentralized Derivatives on Level01: A Level Trading Field for All Investors

Andy was flustered. He had lost almost six thousand dollars trading options in various forex markets with an option broker that provided short term, binary settled contracts.

To Andy, the appeal of these options contracts were their quick results and payouts that were unattached to the magnitude of the underlying market price movement, he was confident that he could predict the market’s short-term movements and earn profits prudently.

His endeavour started out good, with profits of around twenty percent in just thirty minutes of trading; but gradually his profits disappeared, and it became an uphill battle just to maintain his capital until he decided to double down on each trade and lost all of it momentarily.

Andy had an uneasy feeling; his trades were losing from contract positions sometimes just by a hair’s breadth. Comparing the expiration time prices of his trades with external market sources, he noticed the broker was using one, sometimes two additional decimal points for market pricing when compared to external live sources.

Andy registered a new account with a different phone and traded small amounts with it before attempting to trade opposing contract positions simultaneously with his original account. The trades were not registering at the same time, and he was only half surprised to lose both trades, with the expiry just barely out of reach of both trades’ entry strike price!

And therein lies the problem, Andy is one of millions of individual investors that are at the mercy of a brokerage platform’s settlement system. Such options platforms provide structured products that are shorter term and use dynamic strike (target) prices, making it difficult to evaluate legitimacy of the settlements.

Minute details like additional decimal points in the market price also allows for potential rigging of contract settlements; especially considering that the brokers are mostly trading against the users, and it is difficult to hedge such short-term dynamic positions.

Aside from the possibility of rigged settlements, investors must contend with negative cumulative returns from winning payouts, because the risk/reward ratio for the option position taken is always unbalanced and in the broker’s favour. Mathematically this is proven that over time, investors will lose money because once they start to lose trades, it becomes very difficult to regain profitability before losing all their capital due to the imbalanced offered payouts.

A primer on Derivatives and Options

Derivatives are powerful financial products which can be used to hedge financial positions, to trade risk efficiently, and for speculation — which can lead to substantial gains or losses over very short periods of time. While speculation is frequently compared with gambling, study of the underlying market asset, technical analysis and other informed decision making distinctly separates the two as gambling outcomes are entirely dependent on chance and randomness.

Options are a form of Derivatives and are contracts which have their value derived from an underlying asset. The underlying asset could be a stock, digital asset, commodity, or currency; anything that has a publicly traded price and value. Derivatives gives investors exposure to the asset without having to hold the asset, and the ability to easily transfer risk from one party to another.

Options are derivatives in its simplest, purest form: predictions of a market’s price movements within a certain timeframe in a contract between two opposing parties.

Options are available through many broker platforms, however registering for an account to trade in options can be prohibitive with many regulated brokers only serving certain jurisdictions and having many financial and documentation requirements. Also, certain instruments such as debt securities, renewable energy securities, water rights and lumber as examples are more readily available on overthe-counter dealer networks and brokers.

Such reasons have led many investors to trade options on secondary broker networks and platforms which unfortunately carry a higher risk of misconduct or counterparty default.

The Level Trading Field

Level01 is a decentralized derivatives platform developed with blockchain settlement technology. Since its inception, our goal has been to empower all investors with the freedom to trade derivatives in a globally accessible, transparent, and secure over-the-counter network.

Options contracts traded on Level01 are cash-settled and fully collateralized on-chain, eliminating all possibility of counterparty default while allowing settlements to take place sans a broker.

Our Thoughts on Decentralization

The first thing we asked ourselves, do our users really care about decentralization? And the short answer is most users are indifferent to it, because familiarity with centralized systems is considered the norm. Then why build it is the next question, because Derivatives platforms (especially blockchain-based versions) are orders of magnitude more complicated to develop than their spot trading counterparts.

The answer is because it adds real tangible value to the end user in terms of transparency, control of funds and equal accessibility. These ideals may not be fully realized until blockchain networks can scale accordingly as platform performance and keeping trading costs down take precedence; however ultimately, it is designed into our platform and constitutes the core part of our architecture.

Most retail investors are accustomed to structured products when trading derivatives as these were provided by brokers on their platforms. Many such products have built-in implicit cost: substantially reduced profits for the risk taken, leading to a poor return on investment.

We felt that this would not work very well in a peer-to-peer environment, neither side of an option trade should be exceedingly more advantageous at the expense of a counterparty. Furthermore, investors would not be naturally inclined to know the true value of the options they trade. All these factors would lead to poor liquidity on the platform.

To facilitate peer-to-peer trading on the platform, we initiated a paradigm shift with the creation of the platform’s FairSense AI.

Trading with FairSense AI Analytics

We wanted investors to be able to properly evaluate the true value and risk vs reward of the options they wish to trade. To this end, we developed ‘FairSense’, algorithms using interbank rates which provides in-the-money probabilities for any option traded on our platform.

In peer-to-peer options trading, investors put up a percentage of the contract’s notional value with counterparties contributing the residual amount. Options buyers can use the FairSense probability rates to ascertain the reasonableness of the option purchase price; if they are paying much higher than the in-the-money probability percentage wise, the option is considered expensive.

FairSense probability rates fluctuate according to the underlying market price movement and reflects the probability at the current point in time with built-in volatility and time decay (theta) consideration. FairSense is not able to predict a market’s future price but is an accurate estimate of market volatility and market sentiment, making it an excellent analytic tool for the imminent derivatives investor.

Liquidity Pool Staking

To enhance our platform liquidity towards a global scale, Level01 has developed a liquidity pool staking feature that allows investors to earn passive income and pool rewards according to their pool contribution. The pool is used to perform automated market-making, increasing the liquidity of the platform through automated options writing and hedging strategies

As we continuously expand our platform features, there will be an opportunity to provide curated financial products in the form of options contracts according to individual investor preference and risk appetite. Level01 will soon deliver a suggestion feed with customized contract positions that builds on an individual’s past preferences.

We have 3 distinct near-term objectives:

1) Provide simple yet wholesome access to new investors wanting to trade derivatives contracts. These will be in the form of 1-tap contract positions that do not require investors to place orders. There will be different category filters to sort these contracts, such as: highest risk and return, best value, and highest win probability.

2) To assist investors to attain maximum returns for their risk through FairSense analytics, in a secure peer-to-peer environment.

3) Develop new investors to advanced traders, with capability to write advanced options positions and take advantage of FairSense analytics and market sentiment.

Derivatives in DeFi, Another Gamechanger

With the ability to stimulate whole economies in traditional legacy finance, derivatives in decentralized finance is just getting started; currently just 150 billion value in DeFi compared to trillions of derivatives value in the global financial ecosystem.

As we see tokenization of more asset classes and newly developed instruments such as algorithmic stablecoins being introduced, there is no denying the feasibility of a globally connected decentralized infrastructure for financial derivatives to accommodate both risk adverse and risk inclined investors.

The complexity of derivatives has long kept it out of most retail investors and even some institutional investors investment portfolios and activity. Decentralization provides easier access and the ability to build structured financial products that can be immediately validated, unlocking a whole new range of legacy and newly developed investors.

We are excited to be builders and proponents of this exponentially growing industry and hope you will join us on our journey to become one of the leading platforms in DeFi.