If you’ve read any article on options before, you probably know by now that options in TradFi is a big deal. In fact, the notional value of stocks represented through daily options trading has exceeded the spot last year in the U.S. for the first time ever. That doesn’t even count other derivative instruments – futures, swaps, and others – which combined exceeds market capitalization of equities by orders of magnitude.

Options appeal to different market participants as they unlock investment strategies that wouldn’t be available with spot instruments. Here are just a few reasons why someone would buy or sell options:

• Portfolio protection (insurance). Selling your assets at a higher price than available in the market;
• Inherent leverage. Options provide exposure to much higher notional value than spot does;
• Trade structuring. Expressing a view through a structure that is most cost and/or capital efficient – thereby leading to better risk/reward;
• Yield. Selling optionality and collecting premium in exchange.

A lot of growth in DeFi has been accompanied by the expectations of “institutionalization”. As blockchain developers build novel products, and TradFi willingly navigates the compliance minefield, the on-chain opportunity for options, derivatives and structured products becomes increasingly evident. However, the on-chain traction today in options is minuscule compared to what’s available on centralized exchanges like Deribit. The graph below shows open interest (OI) in options which should give a conclusive idea on the depth of liquidity available:

Not only the liquidity is more readily available off-chain, but there is also a broader range of option maturities and strike prices compared to on-chain protocols (which usually offer 1-2 short-dated maturities and 3-5 strike prices).

In this article we ponder the general trends in the on-chain options space, what are the existing pain points, and what could be done to improve the options products. It is clear that founders understand the size of the prize. We’ve seen an explosion of option protocols lately, and more are expected to go live over the coming months. To us it is evident that the winning products are yet to be built.

Not all options are created equal

The landscape of options has changed drastically over the last 12-18 months. At the start of 2020, Hegic was the dominant options protocol that attempted to create pools of liquidity capable of selling puts and calls. Fast forward to today, we have various iterations of so-called Liquidity Pools (including AMMs), Order-books, Structured Products, and their sub-group which we named Sustainable Yield Products. Each category has at least a few protocols that are live or under development. The total options TVL is around $1B, and is mostly available on Ethereum, Arbitrum and Solana.

We summarize the on-chain options landscape as follows:

Perhaps unsurprisingly, the most successful product-market fit to date has been found by Structured Products. These protocols, also commonly known as Vaults, allow users to sell volatility (i.e. underwrite covered calls or protected puts) for a premium that, for better or worse, is seen by some as an alternative to liquidity mining. Throw in some token incentives on top, and in some cases you’re looking at APYs as high as low triple digits. Following the initial deposit, the user doesn’t have to perform anything, as option maturities (weekly for the most part) and strike prices (10-30% vs spot) are pre-selected and rolled automatically by the protocols. While the most popular underlying assets are ETH and BTC, there are also available products for AVAX, SOL and some other tail assets. These Structured Products have accumulated $600M in TVL, with Ribbon Finance leading this category. It is worth noting that most of them use largely the same off-chain market-makers to auction the options they are selling and thus premiums. We expect a long-term winner in the Structured Products category (as defined today) to be able to offer the following:

• Products with unique pay-offs that are initiated and led by the community effort;
• The most competitive fee structure.

One trend observed this year is dampening of short term implied volatility as a result of heavy selling coming from Structured Products protocols (off-chain market-makers that buy these options have to hedge by selling similar options on Deribit). This suggests that there might not be enough natural demand to absorb the growing TVL in Structured Products, which we only expect to continue as this product has a simple and attractive yield proposition to users. Some protocols have started to address this by allowing anyone to bid on-chain and compete vs market-makers on pricing – which is a welcome development.

The following graph shows implied volatility in ETH declining from mid-December. We think this has been the result of both lower realized volatility, as well as selling induced by Structured Products which saw strong growth in 4Q21.

Selling options closer to expiration has also created a steeper term structure of implied volatility. This is because market-makers sell specifically short-dated options to hedge weeklies bought from Structured Products.

Even worse for Structured Products, there has been dampening of volatility observed right around the auctioning of weekly premiums, as market participants know in advance that heavy selling of options would occur, and push implied volatility lower, thereby leaving less yield for Structured Products users. Protocols are left with an open question – should more risk be taken (i.e. underwriting options closer to ATM) to compensate for yield that’s being compressed, or should this market force naturally balance the supply and demand for volatility selling? Friktion team has started to address this by experimenting with different weekly auction times (depending on the asset) to capture higher implied volatility.

In parallel to the aforementioned Structured Products, we also define a distinct group of protocols that we call Sustainable Yield Products. Protocols like Opyn, Brahma.fi, Primitive, Friktion, Vovo are different from one another, and it is difficult to come up with a unifying term. However, these protocols are building yield products that offer unique pay-offs, or allow principal protection while relying on yield sources that are sustainable in perpetuity. There are some interesting applications today, and we think this section will greatly expand over the coming year:

• Hedged LP positions;
• Hedging of options exposure (for market-makers);
• Perps funding payments as a yield product;
• Synthetic option selling through concentrated LP in AMM;

We see this category of products potentially unlocking use cases at protocol-to-protocol level, where structured products are applied to protocol’s treasury for risk management and capital efficiency purposes. These protocols are fairly young and niche, but Opyn’s squeeth (squared ETH) product has found a product-market-fit already, and is one of the building blocks for the aforementioned use cases. We also note that squared products like squeeth actually consolidate liquidity, rather than fragment it across different option strikes prices and expirations.

Next, we look at Order-book protocols that attempt to build options as we know them on centralized exchanges. These require high-throughput blockchains guaranteeing cheap and fast execution, therefore, Solana has been the go-to environment for this category. Zeta Markets and Psyoptions aim to provide under-collateralized and cross-margined options trading venues. Also, Order-book protocols are an important piece of infrastructure in the options landscape, as Structured Products are using them to mint and settle the options. We think the winning product among Order-book protocols in the long term will be able to:

• Offer a full suite of decentralized derivatives that together reinforce liquidity and price discovery, while ensuring under-collateralization and cross-margining;
• Ensure highest on-chain liquidity (which is currently lacking but being addressed as private sale investors are joining as on-chain market-makers);
• Have maximum utility as minting & settlement infrastructure by allowing modularity (strikes, expirations, European vs American options, cash vs asset settlement, etc) for protocols building on top.

Finally, Liquidity Pool protocols are working towards quoting and underwriting options on-chain, without the help of Order-book protocols or off-chain market-makers. Dopex, Premia, Hegic can be seen as advanced Vaults, with a marginal improvement of being able to quote options and sell them to on-chain buyers themselves. These protocols have had limited success, growing to over $100M in TVL. We see at least one design trade-off made by these protocols that hinders adoption:

• The pool is only able to underwrite the options, but not buy them back;
• Liquidity providers are unable to select strike prices at which their options will be underwritten;
• Pricing of options ignores the deposit utilization in the pool;
• Liquidity providers are exposed to the underlying, i.e. not hedged in a way like a true market-maker would be.

These products go a step beyond the Structured Products (Vaults), but ironically are in an inferior position when it comes to finding a product-market-fit.

Alternative approaches to Liquidity Pools are taken by Lyra, Primitive, Pods and some others. These teams are building decentralized market-makers, or options-specific AMM. We see this group ultimately competing against the _Order-book _protocols on Solana, therefore the winning product should have a value proposition built around capital efficiency (under-collateralization) and option pricing.

Supply & Demand: Where On-Chain Options Fail

While options have been growing faster than other products in DeFi (until very recently), the success is comparatively small when looking at the number of users, option volumes vs spot volumes, and the previously discussed difference vs on-chain OI. To explain this, we attempt to look at sources of options liquidity first, and then break down the logic behind supply and demand for options products.

Providing liquidity: Traditional market-makers going on-chain

Traditional market-makers require a single venue with deepest available liquidity that provides multiple derivative products (options, perpetuals), and allows under-collateralization with cross-margining. There are several protocols leveraging this on Solana and we expect them to get significant traction over the coming year, especially as they integrate with Solana’s Structured Products. These projects either haven’t launched yet, or have launched very recently, and we believe that this approach is yet to be validated by the market.

_ Providing liquidity: DeFi-native market-makers (decentralized market-makers & option AMMs)_

We see several pain points in providing on-chain liquidity for options:

• Most options, by design, expire worthless. What this means is that an LP will most of the time trend toward 100% loss. To mitigate this, protocols need to protect LPs at the expense of capital efficiency, liquidity available in the AMM and price discovery; - Prohibitive gas costs. Most of the option protocols have been built on Ethereum while L1 gas prices have grown. Options are particularly sensitive to gas given premiums have comparatively low dollar value;
• Decentralized market-makers have to be hedged. For a pool of liquidity to underwrite options and to be able to sell them both ways, it has to be hedged. The technical implementation of a product like this is perhaps the most difficult of all options protocols, as not only it has to dynamically calculate risk for its LPs and price options accordingly, but also find ways to hedge its exposure through spot or futures. Ideally, such a product would be built on the futures product on a scalable blockchain, and wouldn’t have settlement issues while executing different legs of the trade.

Now let’s look at supply and demand for options products, once the liquidity has been established by market-makers.

Using available liquidity to sell

We’re inclined to put Structured Products into this category, as they’re aggregating the existing demand for yield (selling volatility), packaging it, and selling it. Our sole reservation is around the fact that these options are sold off-chain, as there is no sufficient on-chain liquidity today.

Using available liquidity to buy

The on-chain option products today are more oriented toward sellers rather than buyers. Up until recently, we have seen only one or two products that are buyer-oriented, and which would leverage composability with other DeFi primitives. For example, providing options to hedge the LP position is a way to create natural demand from option buyers, and build incremental TVL.

We also think that existing on-chain option products don’t sufficiently address the following:

• Large risk appetite of DeFi users;
• The main reason why options became popular among retail stock traders – i.e. leverage.

But here we go back to our previous points – for someone to buy a highly speculative, deep OTM call option on a tail asset (i.e. buying convexity on a token that could go parabolic in spot), there has to be someone underwriting the option – be it a traditional or a DeFi-native market-maker. The options available to buy today are more designed to provide insurance as opposed to give exposure to exponential pay-offs to the upside.

Zee Prime’s Option Theses

We have several theses related to on-chain options and broader structured products…

• Order-books vs Decentralized Market Makers. We think the two will not co-exist. Order-books will be pushing forward as they can offer cross-margining and under-collateralization – the conditions required for traditional market-makers to bring deep liquidity. We are all in favor of seeing a DeFi-native approach to tackling these problems, but most of the Liquidity Pools today advertise the APYs earned on capital, without addressing the risks of being an options underwriter who doesn’t hedge his risk. These types of options underwriters do not earn uncorrelated returns, like market-makers do. Unless under-collateralization (via insurance pools, liquidations) and hedging (via spot, futures or multiple option legs) are nailed out for the liquidity providers, Liquidity Pools will not be able to compete with Order-books. We see Lyra (hedged liquidity providers and under-collateralization) and Primitive (synthetic options in AMM, whose liquidity tokens could be used as collateral, thereby improving capital efficiency) having two distinct approaches to successfully challenge the Order-books.
• All Structured Products protocols will eventually build Sustainable Yield Products. Selling options premiums for income is not a durable long-term strategy. Yields will go down as more and more TVL is chasing the same pool of market-makers who need to offload this exposure to someone else. More products will be built that utilize the crypto-native sources of yield (staking, perp funding, synthetic option premiums as swap fees in AMMs, etc.)
• On-chain options will get adoption as they become more closely integrated with other DeFi use cases. AMMs, money markets, perpetual futures markets all could drive their own liquidity and adoption by attaching options as a risk management tool. This would create a natural demand for on-chain options, as opposed to meek attempts to buy weekly calls and puts close to spot.

…and some ideas as to what options products or use cases could be built next:

• Volatility as a product. The introduction of power perpetuals should allow building an on-chain volatility product (similar to VIX in TradFi, which measures implied volatility from underwritten option prices) that uses an on-chain oracle. Since power perpetuals are similar to everlasting options, their pricing considers the entire options chain as opposed to individual maturities, and thereby aggregates the entire Open Interest. As power perpetuals have no expiration date, it should be possible to create a volatility pricing instrument that is non-existent in TradFi or off-chain.
• Combining covered call selling with stablecoin borrowing for cash-settled options. A seller of covered calls who wants to collect yield and maintain exposure to the underlying asset (e.g. ETH) could use this collateral to borrow stablecoins. The proceeds could then be used to settle the options contract should the underlying’s price exceed the strike at maturity.
• Warrants replacing liquidity mining. We see a case where protocols could replace the traditional liquidity mining with token warrants (a smart contract entitling the warrant holders to purchase the tokens from a protocol treasury at a predetermined price). This would be similar to holding an OTM call option on the protocol’s token. The warrant could become exercisable only if a certain token price is reached, and would have a very low exercise price attached – thereby netting an immediate profit for the warrant holder if conditions for exercise are met. This model yields several benefits for the protocol and its treasury:
• Providing room for the token to grow into higher valuation and deeper liquidity, before the warrants become exercisable, and corresponding tokens get sold by mercenary capital. Ideally, this selling dynamic would be absorbed by the liquidity that has been built up until that point, and the regular dumping of incentive tokens would be contained;
• Treasury is actually raising capital from users, as warrants are exercised at a pre-agreed price;
• If the predetermined token price is not reached, warrants do not ever become exercisable, and expire worthless. The protocol has preserved its supply of tokens, and can use them as incentives again in the next iteration of the project.

See You At The Expiry…

Options, structured products and broader derivatives are all complex. Nonetheless, it is pretty clear to us today that the winning products in this space are yet to be built. Options took more time to take off compared to other DeFi applications, but as blockchain scaling is being addressed, more teams are able to test and implement their ideas.

We’d love to see DeFi-native approaches to options market-making win, as this would truly democratize the field that historically has been inaccessible to retail due to its inherent complexity. The best protocols in this category try to think of traditional market-maker’s mandate from first principles, and then use DeFi-native tools to see them through implementation.

We’d also love to help our elders allocate into structured products that will provide superior (and sustainable) yields over TradFi instruments that the MBA-trained advisors sold them.

Complexity of DeFi (for better or worse) is advancing, more interdependencies are made, while founders and investors tinker with more exotic products. There is one boomer adage that comes to mind during market conditions like we witnessed this year – risk can never be destroyed, only transferred. Option sellers, beware.

Disclosure: Zee Prime has invested in Pods, Brahma, Vovo, Opium and Potion