I’m introducing the framework of a decentralised crypto option trading protocol that incorporates 3 interacting and distinct components:
- A market for option trading with no need to be fully collateralised.
- An oracle for crypto price volatilities.
- A set of tradable tokens based on volatilities.
Options are contracts that give holders the right to buy or sell the underlying assets. The premiums are usually fraction of the spot price, hence giving the holders leveraged exposures. There is also no downside risk apart from the premiums paid. This asymmetric return profile is great as a tail-risk hedging tool for holding cryptocurrencies.
Crypto option trading has been booming. Despite the recent market movements, ETH option open interest had reached1.7 million ETH at the biggest centralised exchange Deribit on 13 May 2021, the all time high. The trading volume also increased tremendously in decentralised exchanges. The total value at Hegic reached US$48 million on 22 May 2021.
Overview
The first component of Moret protocol is the option trading exchange which is backed by an automatic market maker. The AMM operates on two mechanisms: hedging and volatility curve.
The hedging mechanism relates to how options are collateralised. In existing decentralised exchanges, it was common to require a full exposures of option contracts as collaterals. For example, when creating a call option contract on 1 ETH, collaterals equal to 1 ETH needs to be set aside. The consequence of demanding full collaterals is that the amount of option contracts is limited. In addition, collaterals for put and call options aren’t normally fungible, making it difficult to mix both pools without unintended consequence of under-collateralisation.
What if instead, we design the option market to be under collateralised to start with. In this scenario we need a hedging mechanism to manage the exposure. An amount equal to the Delta of the options is set aside as ‘hedging’ positions. The Delta is the change of option price vis-a-vis underlying price. By dynamically adjusting the hedging positions, the AMM will be able to meet that the liabilities with a much smaller capital outlay. Furthermore, it is now possible to mix collateral pools of both call and put options, and more hedging strategies.
Assuming a conservative setup of 100% collateralisation and option exposures limited to to the Market Pool size, the AMM improves the returns to the MP providers. Running the pool for 1-day at-the-money call options yields high returns across the years. Even in the bull year of 2020, the APY for MP providers (in terms of USD) still yielded more than 150%.
Implied volatility decides how much to charge option buyers. The AMM works so that depending on the ratio between amount of options outstanding and available capital in the pool, which I call utilisation ratio, volatility is higher or lower. Obviously the higher the total option exposure compared to the available Market Pool size, the higher option premium it is going to charge.
Also there’s the difference in cost between options with at-the-money strikes and others. The different supply/demand dynamics between different strikes/moneyness need also be reflected in the option cost. The way Moret runs the cost calculation is to formulaically construct the volatility skew so out-the-money option purchasers pay the correct premium.
The second component of the protocol is the volatility oracle. Volatility is a key input to pricing options. Yet existing feeds rely on implied volatilities of trades in centralised exchanges. In order to be consistent with how the market pool works, Moret has an on-chain volatility oracle that would provide a frequently-updated volatility to feed to the option market.
The GARCH approach is used to estimate the volatility based on price feed from Chainlink. Without making assumption about the long-term volatility level (few actually can), the daily volatility is a result of both the latest price change and the latests volatility level. The historical 1-day ETH volatility hovered around 10%. In more recent years, the volatility contracted to around 5%, before experiencing sudden spikes during Mar 2020.
The third and final component is the volatility tokens. The tokens reflect the values of volatilities which allow the trading in volatility itself. People will now have an instrument to trade based on their views on the crypto price volatility. The tokens can be exchanged for options with Moret exchange, and also minted directly by depositing equivalent amount of underlying tokens.
An additional feature of volatility Tokens stems from the mean-reversion nature of volatility. As it is not uncommon to experience spikes in volatility, the range of volatility is nevertheless bound by the nature of statistics. The relative stable value of volatility tokens can both makes them suited for a minor role in the world of stablecoins, and also as a defensive investment against market downturn. While it does not have a full backing of USD collaterals, it nonetheless fluctuates around a long-term level. Furthermore, it does not depend on algorithms based on supply and demand, as major algo stablecoins do.
In the following section, there are more about technical details and development plans.
Technical details
A specification for an option contract contains the following parameters:
- Underlying: ETH
- Types of the pay-off: call or put
- Expiry time: t
- Strike price: K
- Amount of underlying: M
The option price follows Black-Scholes formula:
C = (P ⋅ N(d₁)-K ⋅ N(d₂))⋅ M, where d₁=(ln(P/K)+0.5 ⋅ σ (t))/(σ (t)) and d₂ = d₁-σ (t)
Implied volatility σ(t) is a parameter provided by volatility oracle as mentioned above. This expiry-dependent parameter is driven by both historical volatility, and also supply and demand.
In order to facilitate the quoting, a simplified formula is used in place of the Black-Scholes formula, inspired by here and the fact that option prices consist of two parts: time value and intrinsic value. For example, in-the-money option price works out as C=0.4⋅K⋅σ(t)⋅β + max(P-K, 0). β is a risk adjustment parameter that is set to decline as strike moves away from the current price.
One important consequence of this pricing formula is that the options can be traded in units of volatility. For instance, if price of ETH is $2,000 and σ(t) is 10%, the price of at-the-money call option can be paid in either $80 (=0.04 ETH), or 500 volatility tokens.
Volatility token has specifications in both underlying and time to expiry. So ETH 1day volatility tokens can be exchanged with ETH 1d call or put options with any strike. The volatility token is deliberately detached from skews so all options of the same underlying and expiry can be traded with the same token.
At the same time, the volatility oracle provides a third-party feed for the volatility levels. The parameterisation of the GARCH model is chosen to guard the estimations from short-run spikes while still responsive to the moving trend.
On an on-going basis, the AMM mechanism rebalances its hedging positions according to the aggregate Delta of active option contracts. Running on an auto scheduler, the AMM adjusts the balance between underlying token and stablecoins. The delta is calculated as a step-up function in order to save gas. The frequency of running the rebalance depends on the size of the pool and gas price levels.
The range of aggregate Delta position will be between -1 and 1 times the total capital provided in the market pool. When the Delta is -1 * total MP size, it posts the full amount of pool in stable coins in loan providers, in exchange for loans in the underlying token. When the Delta is 1 * total MP size, full amount of capital is in underlying token. The put and call options are netted in the same pool, hence reducing the hedging positions. The trading between stable coins and underlying token takes place in DEX such as Quickswap or Sushiswap.
In order to support the project, a fix percentage of fee is payable when entering an option.
Development Plan
The development of Moret is expected to finish in 3 phases.
The first phase focuses primarily on the core protocol that runs on Polygon.
- The volatility oracle by sourcing prices via Chainlink.
- Option quoting and automatic market making platform at here. The collateralisation is capped at 100%.
- Volatility token which could be minted and traded.
In the second phase the utilisation function and gas fees are to be improved by migrating AMM and running on multi-chain. The collateralisation will be relaxed to over 100%.
The final phase expects more option strategies to become available, as well as more tokens and expiries. A governance token is expected to facilitate the build-up of capital in MP and trading volume. In addition, a full fledged risk management system is also envisioned to further improve the capability of the AMM.
Please join us to develop this exciting project.
Discord: https://discord.gg/Vy2K5mAKVF
Telegram: https://t.me/moret_crypto
Twitter: @moret_crypto
