Replicating Zero-Liquidation Loans using Deribit Markets
Evaluating fair APRs for ZLLs using Deribit ETH option market data
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We recently explored the underlying optionality of Zero-Liquidations Loans as well as calculating a fair APR for any asset that a lender wants to underwrite a loan for.
On the other side, as a borrower considering using a Zero-Liquidation Loan for the first time, you might wonder about the reasonable APR and LTV at which you should borrow. For instance, if you want to use your ETH to borrow USDC, what would be a fair APR and LTV for you? While previous articles have explored a theoretical pricing approach (i.e. Black-Scholes Model) to this, there’s another mental model we can refer to: a replication strategy.
Surprisingly, one can use Deribit, a leading marketplace for crypto derivatives, to emulate a Zero-Liquidation Loan and associated payoffs. Let’s explore how this can be done 👇
Zero-Liquidation Loans with Deribit
Let’s imagine a simple theoretical scenario where you hold 1 ETH and want to borrow USD against if for about a month. A replication strategy that allows you to emulate such a Zero-Liquidation Loan can be presented in three steps:
- Sell your ETH for USD.
- Use part of your USD to buy an in-the-money ETH call option.
- Retain the leftover USD as your loan.
To best visualize this process, let’s walk through a numerical example:
If ETH is currently trading at ~$1630.50, selling 1 ETH yields $1630.50. Let’s say you buy a call on ETH with a strike of $1,100 (in-the-money) set to expire in 24 days.
The mark price for this call on Deribit is 0.3275*1630.50 = $533.99. If you place a limit order and it’s filled, you’re left with $1630.50 — $533.99 = $1096.51.
This means that you’ve effectively received $1096.51 as short-term funding and preserved your potential upside with ETH — all thanks to the call option. This means that if the price of ETH surges (or even slightly dips, since the call is in-the-money), you’ll retain your ETH position.
Unlike conventional on-chain liquidation-based loans, you’ll never have to worry about potential liquidation penalties or seeing your ETH being auctioned off — even in the case of an oracle failure, flash crashes, etc.
This relatively simple strategy allows us to achieve a syntenic Zero-Liquidation Loan using a Deribit ETH option chain as the underlying market to ‘fairly-price’ our loan.
Now, based on the above example, what is the resulting APR for this synthetic Zero-Liquidation Loan?
Since the option’s strike price is at $1,100 and you effectively received $1096.51 as short-term liquidity, your effective APR is:
(1100/1096.51–1)*365/24 = 4.84%.
To translate into terms of an implied LTV, you received $1096.51 in cash against ETH collateral valued at $1630.50. Thus, your implied LTV is 67%.
This example is specific to a particular call option and implied LTV.
But what if you were interested in obtaining different loans with varying LTVs — what kind of APRs would be reasonable at each loan?
To figure this out, we can simply do the same calculation as before but for different strike levels. We can plot the implied APRs versus their respective LTV levels to visualize this relationship. As expected, a higher LTV results in a higher APR — notably, the APR curve closely resembles the volatility skew seen regularly in traditional options.
Replication Strategy
Users can thus emulate a Zero-Liquidation Loan by swapping their collateral for USD, purchasing a call option and saving the leftover USD as liquidity. This replication strategy reveals many insights about fair APR and LTV levels.
Based on the “law of one price”, prices should, in theory, align, whether you replicate a Zero-Liquidation Loan through Deribit or use a platform like MYSO. However, these may only be “somewhat similar” due to distinct factors. For instance, Deribit users bear counterparty risk, while MYSO users face smart contract risk. Furthermore, replication is feasible only with a liquid option market. Midcap tokens might not support such strategies if corresponding call options are absent on Deribit and/or other platforms.
However, for ETH and BTC, replication strategies can be a powerful tool to reason about Zero-Liquidation Loans and offer a clearer perspective on suitable APR and LTV rates.
Hopefully you now have a clearer view into how you can tap into a Million Yield Structuring Opportunities with MYSO v2. We welcome any and all users to create new strategies and for projects building on MYSO to create their own bespoke market to secure a healthy yield while promoting additional utility to their native token!
Be on the lookout for future updates and releases!
