PsyOptions: Protocol Opportunity and Challenges
Product Introduction:
PsyOptions is a decentralized options exchange built on Solana. The project won first place in the inaugural Solana x Serum hackathon in March 2021 and launched on mainnet in late August.
The platform itself is relatively simple: a central limit order book for physically-settled options. PsyOptions currently offers puts and calls on BTC/ETH with various strikes through a straightforward UI.
The product will be familiar to anyone accustomed to trading options in TradFi but is unique in the DeFi space. DeFi has struggled with derivatives given the transaction cost and latency inherent in public blockchains. Options in particular face challenges around required user sophistication and on-chain margin capabilities. PsyOptions developed interesting solutions to these problems and could be a key piece of the Solana DeFi ecosystem. Before exploring its unique attributes, a brief review of the current options landscape.
Market Opportunity:
Options are a large and lucrative asset class in traditional finance. For context, during September 2021, U.S. equity-linked options volume was $250bn[i], crypto options volume was $28bn[ii] and crypto perpetual volume was over $1.5tln[iii]. Options are a natural fit for crypto given the high retail participation with speculative impulses and desire for yield. The market is stunted by the current dearth of venues with Deribit, a Panama-based exchange, processing virtually all trades.
Deribit offers a strong product but the lack of alternatives is holding back development of a more robust ecosystem. Retail traders traditionally generate a large and profitable source of options flow via direct participation and indirect activity from structured product investments[iv]. As a centralized exchange, Deribit prohibits retail users from many large crypto markets (U.S., Japan, Korea, etc.) and requires thorough KYC verification in their onboarding process. Retail activity is negligible given these constraints.
Crypto options’ heavy skew towards institutional participation dampens overall activity. Alameda would much rather trade against odd lot retail than peers like Jump Trading. At the moment, options are mostly institutional, so market makers quote wider spreads to offset their risk of primarily serving others with an informed market view. Wider spreads result in fewer trades and an overall less vibrant ecosystem.
A DeFi options platform resolves many of these barriers to entry. Censorship resistance, one-click on-boarding and composability with other DeFi platforms will bring important balance to flows and help the market grow.
PsyOptions Product Differentiation:
The protocol is the first to operate on Solana and integrate with Serum. The architecture delivers negligible fees (<$0.01), almost immediate transaction processing and limit order entry. The entire experience is comparable to trading on Deribit or any traditional exchange.
Opyn, an Ethereum-based competitor, offers an order book with limits but each bid or ask requires costly gas fees. This is uneconomic given the frequency of price updates required for market making in crypto. Other competitors utilize an option market making (OMM) algorithm to reduce on-chain activity. These formulas are imprecise as crypto option valuation is unchartered territory. What is BTC or ETH’s risk-free rate? Is the market even efficient? Order-book processing ensures competitive pricing whereas an OMM often disadvantages one side of the market based on formulaic assumptions.
PsyOptions instruments are unrestricted and fungible SPL tokens on both sides of every market. Holders can freely trade for the duration of the contract tenor whereas OMM platforms require holding to maturity or repurchase by the issuer at algo-determined prices. Opyn options are ERC-20 tokens but have the associated transaction fees.
Overall, PsyOptions is setup to encourage market maker participation and robust liquidity through the entire option tenor. This framework enables more trading strategies vs. the algorithmic buy-and-hold products from on-chain peers.
Liquidity Flywheel:
The largest challenge for PsyOptions is generating critical mass of market maker and end user participation. As of early October, the exchange has BTC and ETH options with four strikes each across a single expiry (Oct-29) (screenshot of BTC options at beginning of article). The order books for all 16 instruments are live and at-the-money instruments are competitive with Deribit albeit with far less liquidity. Market makers want to provide liquidity but they need to see sufficient organic volume to justify the infrastructure investment. Retail flow is the key to ramping volumes and market maker entry[iv].
Direct retail trading is one source of liquidity, though likely to remain a somewhat niche activity at this stage of the market. Robinhood has shown retail’s interest in option speculation but their gamified interface and centralized product simplify the process. As currently setup, PsyOptions has complexities including non-intuitive prices and required physical delivery within 24 hours of expiry (i.e., users must deliver specific quantities of wrapped ETH/BTC within a 24-hour window to redeem profitable trades or the contract expires worthless). These hurdles can be easily abstracted away with other DeFi products but direct trading may not take off in the near-term.
Yield farming aggregators present the most promising source of initial liquidity. Asset management products like Yearn are capturing massive TVL as they enable users to passively participate in increasingly complex yield farming across chains. Covered call and put writing option strategies are classic sources of yield in traditional markets that should be replicated in crypto. These strategies are gaining traction in DeFi with recent Coindesk and Bankless features highlighting the benefits[v].
Ribbon Finance leads the charge with $115mm of assets dedicated exclusively to options yield farming. StakeDAO is another aggregator growing their presence in options. Investors are earning 40–55% yields on ETH/BTC in covered call strategies while retaining upside if prices spike[vi]. The aggregators enable completely passive participation as managers select strikes and manage rollovers.
Ribbon currently uses Opyn to write options and sells them to market makers via Gnosis batch auction for monetization. In practice, this is an OTC option sale wrapped in a smart contract for distributions/redemptions. A liquid CLOB-powered protocol would give Ribbon more competitive pricing on its instruments. Ribbon restricts itself to weekly options and retains a 10% cash buffer to manage liquidity requirements since its collateral is locked in the contract. The freely tradable PsyOptions instruments would provide liquidity on demand and eliminate the need for 10% uninvested capital that drags on performance. Ribbon could also engage in more diverse strategies with longer contract periods and various strikes.
Ribbon generates substantial trading activity with over $100mm of options rolled weekly. Moreover, the volumes are predictable and mostly price insensitive. These are precisely what attracts market maker participation and creates critical mass.
Solana’s yield farming ecosystem is less developed than EVM-based chains but should be rapidly evolving. PsyOptions is sponsoring a hackathon prize for integrated projects with at least five reportedly in process. As yield aggregators mature in Solana, options strategies should attract TVL. Passive aggregators are the most promising route for PsyOptions to break the liquidity trap.
Token Issuance and Incentives:
Well-designed token incentives are the second lever PsyOptions has to boost volumes. A late September developer call included a brief discussion by team leadership around possible issuance formats and utility functions. Their July roadmap includes a Q3 private capital raise and Q3/Q4 token launch[vii]:
“We set out to build a community driven protocol and platform. With that we plan to launch a governance and utility token in the near future. We aim to create as fair a launch as possible and want to encourage our community to be as vocal as possible.
Make note that we are product focused. Product first, then token.”
Token incentives abound in DeFi but a launch paired with well-structured incentives and steady aggregator volumes offer PsyOption’s best path towards becoming the dominant on-chain options protocol. The pending private capital raise could be another positive if it brings in the right strategic partners.
[Note: I have no affiliation with PsyOptions or non-public knowledge but some exploratory protocol usage may be a good idea for those with dYdX airdrop FOMO].
Margin Requirements:
Collateralization remains the largest structural impediment to competing with Deribit or other centralized venues. As currently setup, PsyOptions writers must lock the entire underlying instrument in a smart contract for the duration of its holding period. For example, if selling one-month calls on ETH, the entire quantity of ETH will be sitting unused in a smart contract. This represents 100% collateralization and is far greater than the likely market exposure of any given contract (i.e., ETH would have to double within the contract period to lose this quantity of value). For comparison, Deribit typically only requires 15–20% margin for at-the-money contracts.
If PsyOptions is 5x less capital efficient than Deribit, market makers must charge a higher spread to compensate and pricing will be less competitive. The team understands the issue and a fix is reportedly in process. This seems like a problem worth prioritizing. The currently competitive pricing versus Deribit despite this inefficiency is notable.
Cross margin provision for a delta-hedged portfolio poses a far more complex problem to solve on chain. For background, market makers typically limit directional market exposure by using an offsetting combination of options and spot/perpetual products[viii]. The portfolios consist of a large number of outstanding positions with low net exposure to market moves. Centralized exchanges look through to the net exposure and only require traders to hold that market exposure plus a cushion depending on notional outstanding and other risk parameters. PsyOptions will be less capital efficient and therefore less competitive until some cross-margin functionality is developed.
The tradable SPL tokens ease this challenge as margin solutions could come from other protocols rather than PsyOptions itself. This is the beauty of composable DeFi. The team is explicit they need help from other projects to leverage the full power of their underlying options infrastructure.
Mango Markets is an interesting partner to this end. The teams know each other well as co-winners of the March 2021 hackathon. Mango has one of the most developed cross-margin and liquidation engines in the DeFi space to pair with its perpetual offerings. Perps are also important tool in delta hedging any option-related exposure. Mango could integrate PsyOptions to provide a one-stop shop for market making on Solana with in-house hedging and liquidations. This prime broker framework would allow DeFi markets to be competitive with the leading centralized derivatives exchanges.
Other Use Cases:
PsyOptions could play a role in the movement to monetize NFT ownership. The platform provides option functionality for any physically-deliverable SPL token, not just liquid financial instruments. NFT owners can sell covered calls on specific NFTs to generate yield or buy puts on their art to lock in price gains while continuing to hold the work in the hopes of appreciation.
The team has also mentioned using the base infrastructure as a way to grant long-dated stock options to DAO participants in a way that resembles startup equity grants[xi]. If tokenized stocks proliferate, options will be easy to replicate on chain with their infrastructure.
Physically-deliverable options are an important tool in the ecosystem and could serve many interesting use cases as the market develops. The TAM extends well beyond financial options trading.
Conclusion:
PsyOptions is an exciting project with unmatched capabilities within its vertical. Many options projects have failed but PsyOptions offers the best opportunity to break that streak.
The current regulatory environment reinforces the importance of censorship resistant venues and dYdX has demonstrated on-chain derivatives with novel scaling solutions can compete. Could this winter be DeFi derivative season?
If anyone has comments or wants to discuss further, my DM’s are always open on twitter (@brian_smith_0). Follow me there for more research on the DeFi ecosystem.
Note: I have no affiliation with or private information regarding PsyOptions.
Footnotes:
[i] https://www.cboe.com/us/options/market_statistics/market/2021-09-30/
[ii] https://www.theblockcrypto.com/data/crypto-markets/options
[iii] https://tokeninsight.com/perpetual/market_data?source=sharelink
[iv] Robinhood’s payments for order flow revenue is interesting as a ballpark estimate of retail option profitability for market makers. PFOF revenue as a percent of AUM for equity-linked options are 48x greater than spot stock trades. They are over than 8x more valuable than spot crypto trades. These figures are AUM-based rather than per trade but show market maker interest in retail option flow. There is a reason Robinhood pushes options so hard despite the PR issues. Source and more detailed discussion: https://www.bloomberg.com/news/newsletters/2021-07-02/robinhood-ipo-filing-is-a-lesson-in-meme-finance-kqmkzfxc
[v] See: https://www.coindesk.com/markets/2021/09/30/move-over-carry-trade-these-retail-friendly-defi-options-strategies-yield-12-30/ and https://newsletter.banklesshq.com/p/how-to-make-money-with-automated.
[vi] Good introduction to strategies utilized by Ribbon and others: https://medium.com/opyn/understanding-perpetual-vaults-in-defi-structured-products-with-underlying-options-strategies-27610254475e
[vii] https://medium.com/psyoptions/psyoptions-roadmap-8d239a6366ee
[viii]https://web.archive.org/web/20151107021006/http://www.risklimited.com/Delta-Hedging.pdf
[xi] https://medium.com/psyoptions/the-options-are-limitless-58dddbd28cb4
