Seeking Alpha — Option Selling as a Sustainable Yield Source
Exploring the dynamics of rewards in DeFi and MYSO’s implementation of option selling for sustainable yield
One of the main mantras of DeFi has been to facilitate financial interactions seen in traditional markets in a trustless, decentralized manner. Breakthroughs in liquidity pools and AMMs have allowed for a variety of these financial services to be brought on-chain, revolutionizing trading and debt markets. A common metric from which users derive value in these interactions is yield — and while traditional investors and crypto enthusiasts may have varying degrees of risk tolerance, enhancing yield is a key driver among both demographics. Traditional investors are used to buying high dividend-paying stocks, trading OTC yield-enhanced notes, or investing in a variety of structured products to increase their yield. Similarly, crypto investors utilize a variety of strategies to achieve the same goal, such as staking a protocol’s native token, collecting trading fees as a liquidity provider on an AMM, or lending on a decentralized debt market.
This insatiable desire for yield sparked a massive inflow of liquidity into DeFi, with yield farms and other primitives gaining massive traction at the onset of the 2020 ‘DeFi Summer’. New yield-generating protocols began popping up every day, and with a wide array of new L1 chains, investors were given a wide, albeit risky, playing field.
However, while gleeful optimism was vast, many of these yield-generating protocols were operating with mechanisms resembling those of ponzi schemes (ponzinomics, if you will). For example, vault pools on yield farms generated gargantuan APYs, but with a small catch: rewards were almost certainly denominated in a protocol’s native token. This intrinsically created perpetual downwards sell pressure on said tokens, forcing those that were last in providing liquidity to always bear the loss. These same liquidity mining programs have been iterated over hundreds of protocols across many different chains and began to be layered with different product offerings and supposedly “sustainable” strategies.
Eventually, this sort of reward design was unraveled by the collapse of the Terra ecosystem, with Anchor Protocol at the helm of the wealth destruction. As many of you know, Anchor was a yield farm propped up as a “fixed-interest instrument” that allowed for up to 20% APY returns on staking the native UST stablecoin. The protocol advertised that it was using “diversified staking yields, money markets and the ANC token incentives and governance” to offer such a large, “sustainable” yield. This narrative held up for several months, but as mass outflows from the protocol began to occur and UST de-pegged, a death spiral was in full effect. The entire ecosystem capitulated and the system proved to not be feasible whatsoever.
A Transition in Sustainability
A common misconception with these farming protocols and liquidity mining programs is that self-referential token-reward-loops can generate value out of nowhere and be a self-sustaining yield source. For that to be the case, there would need to be some sort of exogenous value accrual mechanism, like sufficient protocol fees, to generate rewards for users. Otherwise, yield is distributed solely based on future increases in liquidity provisions and no real value is created for the protocol to be able to offer sustainable rewards.
And while so-called crypto natives may sneer at the generally-unexciting yield in traditional financial markets, the downtick in farm forks and recent Terra meltdown have shifted discourse away from formerly unsustainable reward designs towards more viable, sustainable strategies.
New DeFi primitives like MYSO are working to offer users alternative yield-capturing opportunities that derive their rewards from actual value-generative sources. One particular outlet for this, which has been commonplace in traditional finance for decades, is capturing volatility through options.
A sustainable yield source is focused on long-term maintenance of returns — this focus is most supported by factors that aim to be everlasting or even inevitable. In any financial market, volatility is inevitable as information asymmetry is always present and assets prices are constantly changing.
In this regard, as long as you have volatility in some underlying asset, there will always be differences in expectations among interested parties and a way to transfer associated risk premiums between them. This notion has led to the widespread use of options and option-based structured products which derive and capture their value from expectations of implied volatility.
Options are financial contracts that give investors the right, but not the obligation, to buy or sell some underlying asset by expiry (at a given time in the future, called the expiration date). Option contracts are priced through many factors, such as underlying asset price, time to expiry, as well as a number of metrics that aim to capture the effects of volatility. Options are put to use further in structured products, which package together several complex strategies for users to earn yield on. Structured products that utilize options have been extremely popular in TradFi markets and have made their way into DeFi as investors seek to earn additional yield.
MYSO intends to make use of these dynamics by opening up liquidity providers to a passive option writing strategy, unlocking option selling as a sustainable yield source.
Each interaction on a MYSO market represents a matched borrower and lender — one who provides collateral to take out a zero-liquidation loan, and one who loans out some borrow currency.
From a liquidity provider’s perspective, you receive some collateral — provided by the borrower — and sell an in-the-money call option on this collateral, which gives the borrower the right to return the loan amount (net of fees) and reclaim their collateral prior to expiry. The resulting position resembles a covered call, with a payoff according to the below figure. We’ll describe these dynamics more deeply in the next Research Series piece.
Traditional lending protocols, such as Aave, utilize even more complex option strategies to generate yield. They make use of barrier options, where payoff is conditional upon the underlying asset’s price breaching some barrier level during the option’s lifetime. More specifically, liquidations allow lenders to recover potential bad debt, however, there remains a gap risk if the price falls too quickly and liquidations cannot happen in time. This gap risk can be thought of as a barrier option which lenders are implicitly selling. In comparison with these traditional protocols, a liquidity provider lending on MYSO’s 0xLoan markets is implicitly selling a simpler vanilla option and thus generates a higher premium for bearing the risk that a borrower simply might not repay.
What makes this reward implementation sustainable is that the underlying smart contracts are oblivious towards the pricing of the options, allowing market participants to benefit from loan fair-value mispricing and non-linear risk transferal. Risk-takers and protection-buyers will have varying degrees of risk tolerance and perceptions on the ‘fair’ price of these options, allowing for arbitrage to occur constantly between different loan offerings.
While other protocols exist that offer users option vault products that make use of covered call strategies, MYSO’s 0xLoan markets are unique in design and execution. There is no interlinked dependency on other options markets such as Opyn, which many protocols use on the backend for settlement. In addition, zero-liquidation loans are physically settled, meaning that borrowers can reclaim the underlying asset— conventional DeFi options are typically cash-settled. Another factor that sets MYSO apart is that borrowers and option sellers are actually matched, which is different from other option vault products where investors are typically selling optionality to some third-party market maker. This allows for transparency in how yield is economically derived in an option market setting.
MYSO is an abbreviation for Million Yield Structuring Opportunities, as there are unlimited ways to slice-and-dice risk and construct products around capturing the inevitable uncertainty of the future. Putting volatility to use in a zero-liquidation loan setting is just one groundbreaking approach that MYSO is taking for providing sustainable yield.
We will be releasing more details about option and LP dynamics as soon as our security audit is completed and we are ready to go with mainnet launch. Be on the lookout for further announcement on our social media channels and stay tuned for the next piece in the MYSO Research Series, where we’ll dive deeper into option strategies that we utilize!
