Seeking Alpha Pt. 2 — Option Selling as a Sustainable Yield Source
An in-depth dive into how MYSO implements optionality and achieves real, sustainable yield for liquidity providers
So far, the MYSO Research Series has mainly dealt with the benefits that MYSO’s 0xLoan markets bring to borrowers, such as no risk of liquidations, fixed borrowing costs, reduced operational overhead, etc. However, every market is bidirectional, and lenders in search of incentives are always on the other side of a borrow position. To make 0xLoan markets attractive to these liquidity providers, MYSO implements a passive option-writing strategy, unlocking option selling as a sustainable yield source. As discussed in the previous piece, this strategy lets users capture sustainable rewards by way of option mispricing and implied volatility. Follow along to explore what this means and examine some of MYSO’s underlying design mechanisms!
It is first important to consider that each interaction on a MYSO market represents matching borrowers and lenders — for every newly-taken-out loan by a borrower, every LP in a given pool gets a pro-rata share of the loan (peer-to-pool approach).
Let’s briefly visualize the ensuing position from a LP’s perspective:
- Say that a borrower wants to put up some collateral ‘CToken’ (e.g., ETH) and borrow some ‘BToken’ (e.g., USDC) from a MYSO pool
- As a LP, you receive the ‘CToken’ (e.g., ETH) as collateral from the borrower, which represents a long spot position from their end
- You then give some loan amount of ‘BToken’ (e.g., USDC) to the borrower and also sell an in-the-money call option on the collateral (e.g., ETH) to them, which represents a short call position — this 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
Intuitively, borrowers are thus given the right, but not the obligation, to repay the loan and reclaim their pledged collateral. Since the LP is implicitly selling a simple option, borrowers do not have to deal with the complexities of option knock-out levels (a.k.a. liquidation thresholds) found on traditional protocols. However, there now exists a risk that the value of the pledged collateral becomes less than that of the loaned amount and borrowers might choose to then not repay the loan prior to expiry. If this situation occurs, a LP bears the downside risk and ends up retaining the borrower’s pledged collateral. To make things fair for both sides, the LP should be compensated for this in the form of an adequate yield.
But what would be an adequate yield, and how would we price the option so that nobody is better or worse off from the get-go? Since a zero-liquidation loan can be seen as a swap, where the borrower pledges collateral and receives a loan amount plus an embedded call option, we need to determine a fair value for this call option first.
For example, let’s assume you pledge 1 ETH worth $1500 and you can borrow $700 against it for 30 days. Now, to make the swap fair, you should receive a call option which is worth $800 because this way your position value pre- and post- borrow is the same. In this situation, how should we choose the strike price of the call option such that its fair value is $800?
The most simple way to price a call option is to use the Black-Scholes model, which takes into account several factors, including the current price of the collateral, the risk-free rate, price volatility of the collateral, the loan tenor, and the strike price. Other models also exist, so it’s up to market participants to decide how they want to go about pricing these embedded options and come to their own fair valuation.
Under Black-Scholes assumptions, let’s assume that 1 ETH is worth $1500 and you want to buy a European call option with a loan tenor of 30 days, where ETH volatility is at~ 100% and the risk-free rate is 2%. For the value of the call option to come out to be $800, the strike price would have to be $702.
So, if we were to swap 1 ETH worth $1500 to receive a loan of $700, as well as this call option worth $800, we would have a situation where the position is fairly priced, as we are not better or worse off.
Let’s consider the above example and translate it into an APR — if a borrower takes the $700 loan and ends up repaying the $702 strike price to reclaim their collateral prior to expiry (30 days), the implied APR would be 3.4%.
Let’s take a look at how several loan tenors and LTVs affect fair strike prices and implied APRs given that a borrower puts up 1 ETH (= $1500) with 100% implied volatility.
The Black-Scholes-derived fair APRs do increase for higher LTVs and longer tenors, which intuitively also makes sense, as LPs bear more risk and hence expect to receive a higher APR to be compensated for this.
It also becomes evident that as you increase volatility levels (from 100% to 150%), higher APRs are generated and there are more pronounced differences between the individual LTV-vs-tenor APR combinations.
It is important to consider that although the Black-Sholes pricing model is a nifty tool for fair-strike option pricing, MYSO uses American option expiries rather than those of European options, meaning that the option can be exercised (underlying collateral can be reclaimed) at any time prior to expiry rather than only at the expiration date. Since the underlying smart contracts are oblivious towards the pricing of these options, market participants are able to benefit from loan fair-value mispricing and non-linear risk transferal through the use of Black-Scholes or other option pricing models.
For those that want to try and tinker with different loan inputs, as well as view the underlying pricing code and above examples, we have created a Jupyter Notebook file:
https://github.com/mysofinance/thinking-about-fair-aprs-for-profit-and-fun/blob/main/notebook.ipynb
To run the file:
- Download the .ipynb file from the repo
- Go to https://jupyter.org/try-jupyter/lab/, start the browser-based Lab, and upload the file
- From there, you’ll be able to open and run the notebook.ipynb file — now, you can plug in different inputs to see how strike prices and APRs are changed based on said inputs
- To do this, navigate to the [2] field of code and make adjustments to the various variables within the pricing model. You can also make adjustments the latter code fields, including [3] and [5], to find a fair APR and strike price
- Make sure to run the file from the beginning after making adjustments to any of the code sections. Your option outputs will be shown under each individual code section!
MYSO’s 0xLoans are a valuable alternative to traditional lending protocols for borrowers to be freed from liquidations and other inequitable mechanisms, and for LPs to earn sustainable yield through a passive option-writing strategy. Users will be able to benefit from option mispricing by using their own chosen models to come to loan fair-value valuations and derive yield from this in a real, sustainable way.
We’re excited for liquidity providers to have access to an option-writing strategy that doesn’t incorporate self-referential token loop rewards and other unsustainable mechanisms. MYSO will be DeFi’s easiest loan option that benefits users with real, sustainable yield. Stay tuned for further announcements and updates regarding our security audit! Also, be on the lookout for further MYSO Research Series pieces to get further acquainted with MYSO and DeFi narratives!
