IGNITION: Global Solana Hackaton Overview

Solana Summer was fun.

Being one the world’s most performant blockchain, with it’s high speeds and low fees, Solana is designed to help protocols take off and quickly scale to billions of users around the world. Beyond the tech of the Layer 1, the global Hackathon Ignition, represented an opportunity to see how Solana is already being used for a plethora of projects, including DeFi apps, blockchain gaming, Web3 products, art projects, collectables, and much more.

Ignition was the fourth Solana hackathon and brought together crypto pioneers and developers from around the world to build projects on the blockchain. There were a huge number of teams submitting 568 projects with over 6000 participants and to be honest, the quality of the projects and teams were outstanding and really showed how the Solana ecosystem is moving at insane pace from strength to strength.

We are not here to talk about Solana, we can do that in another post. What dragged out attention was the proposal of the “Grand Champion” of this competition, Katana, an asset management protocol building investment products across the risk spectrum.

In general there’s currently some revolutionary strategies that bridge the worlds of TradFi and DeFi. Use cases include the tokenization of real-world assets (RWA’s) like account receivables, consumer loans in developing countries, non-collateralized loans and like Katana or Ribbon, packaging complex trading strategies into structured products. These are just examples of the possible future of DeFi.

Introduction to Derivatives

A financial derivative is a financial product whose value depends on the value of another asset. They can be classified in various ways, according to their complexity, their characteristics or the agents that intervene in them.

These products include options, futures, collateralized loans, swaps, perpetual contracts, basically an arrangement of instruments that have a value derived from an underlying asset. In TradFi the underlying asset could be anything: a stock, bond, interest rate, commodity, or currency. Ultimately, it gives investors exposure without actually having to hold the asset, and the ability to easily transfer risk from one party to another.

Derivatives in DeFi

Right now, derivatives represent approximately $4B out of a total of over $107B locked in DeFi according to the DeFi Pulse dashboard. While this may seem like a respectable amount, consider that even the most conservative estimates put the value of the total derivatives market in TradFi in the tens of trillions.

In DeFi, there is no broker required. Instead, settlement automatically takes place on-chain, where the terms of the contract are fulfilled. In addition, counterparty agreements are programmatically encoded, drastically reducing the risk for malicious activity. This trend has allowed retail investors to take advantage of opportunities previously restricted to those with brokerage accounts or specialized knowledge.

Here are some of the protocols bringing derivatives to DeFi:

• Synthetix: Ethereum-based protocol allowing for permissionless synthetic asset creation tied to the value of real-world assets
• Barnbridge: risk tokenizing protocol for hedging yield sensitivity and market price
• dYdX: hybrid platform offering DEX, lending and leverage, dYdX is a unique provider of permissionless derivatives.

We are here to talk about a new instrument getting introduced to the DeFi world: structured products. Projects like Ribbon or Katana are providing a new source of sustainable yield for the ecosystem while abstracting away the complexity of the underlying derivative strategies. Thanks to structured products users are going to be able to reap the benefits of derivatives without interfacing with or having deep knowledge of the relevant derivative protocol.

Structured Products: Sustainable Alpha for Everyone

Structured products are packaged financial instruments that use a combination of derivatives to achieve some specific risk-return objective, such as betting on volatility, enhancing yields or principal protection. In other words, packaging multiple investment strategies using a variety of assets into a single product. This is very popular in TradFi ($7tn) and has recently made its way to DeFi and it seems that it is going to change the way we generate yield as crypto investors and open a new door for financial inclusion.

Although it’s possible to create and sell derivatives like option contracts by yourself, there are many risks involved in the process that make them difficult for the regular investor without financial education. Apart from the cost of creating the contracts (gas fees in crypto), you would also need to set the correct strike price and expiry date to balance the risk/reward of the price you can sell an option at vs the likeliness of your option being exercised.

Furthermore, as Katana’s introduction emphasizes, today’s yield generation is largely private and non-collaborative. Closed markets have evolved around the process, resulting in yield-searchers paying yield-generators for access to private strategies.

Thanks to financial engineering, protocols are now able to build structured products, where users can deposit their assets into a smart contract and automatically start running a specific yield strategy while minimizing the risk because of the algorithm. Even more, it opens the possibility for collaborative strategy by using vaults. Beyond alleviating the risks of individual trading, it also alleviates a majority of the gas problems by socializing the gas costs across all the vault depositors. Instead of doing 4 transactions per week per user, the vault can do 4 transactions per week for thousands of users at once.

Let’s see this in action. We will explore Ribbon mechanics, as it was the first protocol to introduce structured products to DeFi. Their main product focuses on yield through automated options strategies. The protocol also allows developers to create arbitrary structured products through combining various DeFi derivatives. We will also make a small preview of Katana’s proposed strategy, the protocol with which we started the blog

Ribbon

Ribbon utilizes user funds to underwrite calls and put options that they sell to other participants in the market with the hope of earning money from the options premium. An “option seller” like the protocol makes money from the premium paid on an option when the option stays “out of the money” (OTM). A call option is OTM if the price is below the strike price at expiry. A put option is OTM when the price is above the strike price at expiry.

Theta Vault is the name of their product and it automates a covered call strategy to earn high yield on ETH. The vaults run covered calls and put selling strategies which basically sell “out of the money” call options on a weekly basis for yield.

With the fund’s users deposit in Theta Vaults, Ribbon writes options on a weekly basis using Opyn’s infrastructure (DeFi options protocol) with a carefully calculated strike price that aims to maximize the sale price of the option while minimizing the risk of the option being “in the money”. Each time they do so, the premium earned by the vaults is returned to the investors of the vault, compounded, and reinvested the following week.

Ribbon’s interface (3 of 5 different Theta Vaults)

The main risk involved with depositing funds with Ribbon results from options expiring in the money. This means users can incur a loss from an option sold any given week depending on the price of the asset. To minimize this, Ribbon has done extensive backtests with option strategies to optimize the risk-return ratio of their vaults.

Katana

At its core, Katana plans on simplifying yield generation on Solana by identifying, composing, and packaging the best strategies in DeFi into accessible yield products.

Built on Anchor’s framework, Katana defines itself as an asset management protocol on Solana, enabling users to passively earn the best yields in DeFi. They are building a comprehensive suite of investment products, starting with structured products and automated vault strategies.

Similar to Katana, the first product to arrive on the mainnet will be structured products (consisting of covered calls and put selling strategies) followed by automated vault strategies.

Final Thoughts

Ideal for both risk averse and risk loving investors, derivatives are a powerful tool to hedge or speculate, and an essential part of any mature financial system.

With the exponential growth and evolution of the DeFi space, it will be interesting to see how the market share of decentralized derivatives changes over time, what new instruments are created, and which underlying assets generate the most demand.

As with any open-source crypto project, competitors are not many steps behind if they choose to get inspired by a project. That’s why we expect many projects to work on structured products with enticing yields to their users utilizing a mixture of options strategies.

AVAX has quickly risen to become a top contender among various Layer 1 crypto networks and one of the main foundations for DeFi 2.0 development. It’s just a matter of time to see how new protocols will come to change the game again by using derivatives.