Welcome to our first piece of content on Mirror!

For a while now, we’ve felt the need to clearly define the technicalities and properties of our products for our upcoming users. We wanted to create long-form content explaining how some things work, and why we chose some solutions over others.

As we also wanted to keep posting summarized blogs on our Substack, we thought it both timely and appropriate to start writing on Mirror. Starting with this article, we’ll begin posting definitive pieces on our strategies and in-depth properties of our products.

With the introduction out of the way, let’s get into it; today we’ll be defining our flagship product, Risk-Adjusted Vaults (RAVs) - more specifically our covered calls vault - in three key points.

As with most DeFi protocols in general, there’s a niche we’re attempting to fill - structured products. We’re initially starting with options vaults, with potentially more derivatives to be utilized in future vaults.

To find our product fit within this corner of DeFi, there’s problems to solve:

In the immature crypto markets, finding accurate pricing for options of different assets has historically proven difficult. As the market microstructure varies greatly from it’s traditional counterpart, options pricing models for crypto aren’t easy to apply.

For example, a commonly used traditional pricing model “Black-Scholes” requires certain parameters to find accurate pricing, one of which is implied volatility - previously something hard to accurately determine in crypto.

Market conditions and the volatility of a given asset directly correlate to pricing, and subsequently yields. So, in order to generate the most predictable yields possible, pricing has to be nailed accurately while ensuring smooth execution.

With vaulted assets in general, an issue arises - capital efficiency. While there are multiple varying solutions for this throughout DeFi, they’re mostly protocol-specific - staking derivatives that are only compatible with the underlying platform, for example.

The problem is, these derivative tokens are difficult to utilize across protocols. As an example, lending platforms might find it troublesome to balance their vaults around multiple different yield-bearing tokens, so they might not want to support them as collateral at all.

This process is simplified with the ERC-4626 “vault'“ standard. It’s designed for composability, easing integration between different protocols.

This is a problem specific to covered calls. As most of the people that found their way here are already likely aware, underwriting covered calls always comes with some level of opportunity risk - the possibility of missing out on the possible appreciation above strike price.

In order to leverage covered calls in a risk-adjusted strategy, we needed to balance underwriting covered calls and simply holding the underlying asset. This also needed to be addressed in a dynamic manner, to account for market conditions potentially skewing with predicted yields.

We’re getting to the fun part now - how we overcome these hurdles to provide sustainable, predictable, and real yield.

As I said before, there’s three key points in defining our vaults - those key points being flexibility, pricing & execution, and automated strategy. I’ll explain these properties in-depth, one by one.

Due to the locked nature of vault strategies, users are generally very limited in the amount of control they have over their vaulted assets. This introduces a level of risk in that if the markets take an unforeseen turn, the user might be left hanging instead of being able to utilize their assets elsewhere.

With Knox vaults, users will be able to withdraw their assets at any time. However, there’s no free lunch; if assets are withdrawn in the middle of an epoch, the user will receive ERC-721 (NFT) short tokens of the underlying asset that can then be sold to Premia’s pools to get the appropriate asset back. This means that while you’re able to withdraw at any time, you might incur a loss doing so.

Additionally, a 0.5% withdrawal fee is involved whenever assets are withdrawn. This is to discourage more active users from constantly moving around assets and to ensure the profitability of a vault.

Besides being able to withdraw short tokens from our vaults at any time, another level of flexibility is unlocked with ERC-4626 vault tokens. Tokenizing our vaults allows users to further leverage their deposits through more exotic strategies, such as collateralizing their yield-bearing positions on lending platforms. As the vault standard is an extension on ERC-20, vault tokens also provide similar basic functionality.

This interoperability provided by vault tokens is also a large contributor to the capital efficiency of our vaults.

Like I mentioned earlier, accurate pricing has been problematic for options in crypto. Pricing and execution are integral parts for generating the most lucrative and predictable yields possible for an options strategy, so this is something that we had to get just right.

A large part of getting pricing right comes from our collaboration with Premia - their on-chain volatility oracle allows us to get accurate pricing for any asset by fetching volatility surface data and applying it to an adjusted Black-Scholes model. In addition to the parameters used by the traditional Black-Scholes, Premia adds both position size and the market conditions of a given asset (supply/demand).

The second part of the solution in execution is on our end - options for our vaults are sold every epoch via Dutch auction. The auction starts at the highest perceived price and gradually & linearly decreases until reaching a price at which all options can be sold simultaneously.

The maximum and minimum price for a vault will be determined/adjusted based on implied volatility values before the auction for each epoch.

Selling via this style of auction ensures both bidders and LPs are incentivized, as buyers can bid their maximum value without the risk of overpaying, while LPs receive the best premiums possible.

Additionally, to secure the profitability of our vaults, the options cannot be sold below the minimum price determined by implied volatility values:

• If there’s not enough bids at or above the minimum price to sell all options, the auction will only be completed partially.

• If there’s no bids at or above the minimum price, the auction will be cancelled and no options will be written that epoch.

These are only security measures - it’s unlikely we’ll even see the latter happen.

Although this is a point that goes without saying in structured products, it’s still worth noting due to the following reasons.

Our vaults operate in automation: they’ll readjust pricing, deploy capital, and sell options according to market conditions. While our vaults can be hugely profitable for more active investors, they’re also an attractive choice for longer-term investors who don’t have the will or capacity to continuously reallocate capital in the ever-changing DeFi land.

For the latter demographic, it’s important to be able to provide a secure alternative to simply HODLing in a non-custodial wallet. This is precisely why we’ve put an emphasis on the predictability of our yields, and also something we’ve based design choices on. The goal was to beat HODLing, and we’ve done so by quite the wide margin according to back-end testing.

While on the topic of strategies, we’ll initially be looking for collaborations with lending protocols on Arbitrum to unlock more exotic vault strategies for our users. Besides the aforementioned flexibility for users, vault tokens also provide a wide array of opportunities for structured products.

Our vaults provide capital efficiency, real yield, flexibility for different types of investors, and composability for the wider ecosystem, while simplifying the process of generating yield through options.

Something worth mentioning, even if they’re called “Risk-Adjusted”, there’s no free pass on risk - although our vaults are designed to adjust themselves based on market conditions, inherent risk can never be entirely removed.

Do remember to never invest more than you can afford to lose. DeFi is still an industry in it’s infancy and anything can happen.

If any questions arose about the mechanics of our vaults, feel free to join our Discord and chat with us!

Knox is a DeFi options platform focused on predictable yields and risk management. With structured products, we automate complex strategies for a wide array of different users from long-term holders to active traders.

In collaboration with Premia, we achieve best-in-class options pricing and execution allowing for capital efficiency and better yields.

https://mirror.xyz/knoxvaults.eth/subscribe

Welcome to our first piece of content on Mirror!

For a while now, we’ve felt the need to clearly define the technicalities and properties of our products for our upcoming users. We wanted to create long-form content explaining how some things work, and why we chose some solutions over others.

As we also wanted to keep posting summarized blogs on our Substack, we thought it both timely and appropriate to start writing on Mirror. Starting with this article, we’ll begin posting definitive pieces on our strategies and in-depth properties of our products.

With the introduction out of the way, let’s get into it; today we’ll be defining our flagship product, Risk-Adjusted Vaults (RAVs) - more specifically our covered calls vault - in three key points.

As with most DeFi protocols in general, there’s a niche we’re attempting to fill - structured products. We’re initially starting with options vaults, with potentially more derivatives to be utilized in future vaults.

To find our product fit within this corner of DeFi, there’s problems to solve:

In the immature crypto markets, finding accurate pricing for options of different assets has historically proven difficult. As the market microstructure varies greatly from it’s traditional counterpart, options pricing models for crypto aren’t easy to apply.

For example, a commonly used traditional pricing model “Black-Scholes” requires certain parameters to find accurate pricing, one of which is implied volatility - previously something hard to accurately determine in crypto.

Market conditions and the volatility of a given asset directly correlate to pricing, and subsequently yields. So, in order to generate the most predictable yields possible, pricing has to be nailed accurately while ensuring smooth execution.

With vaulted assets in general, an issue arises - capital efficiency. While there are multiple varying solutions for this throughout DeFi, they’re mostly protocol-specific - staking derivatives that are only compatible with the underlying platform, for example.

The problem is, these derivative tokens are difficult to utilize across protocols. As an example, lending platforms might find it troublesome to balance their vaults around multiple different yield-bearing tokens, so they might not want to support them as collateral at all.

This process is simplified with the ERC-4626 “vault'“ standard. It’s designed for composability, easing integration between different protocols.

This is a problem specific to covered calls. As most of the people that found their way here are already likely aware, underwriting covered calls always comes with some level of opportunity risk - the possibility of missing out on the possible appreciation above strike price.

In order to leverage covered calls in a risk-adjusted strategy, we needed to balance underwriting covered calls and simply holding the underlying asset. This also needed to be addressed in a dynamic manner, to account for market conditions potentially skewing with predicted yields.

We’re getting to the fun part now - how we overcome these hurdles to provide sustainable, predictable, and real yield.

As I said before, there’s three key points in defining our vaults - those key points being flexibility, pricing & execution, and automated strategy. I’ll explain these properties in-depth, one by one.

Due to the locked nature of vault strategies, users are generally very limited in the amount of control they have over their vaulted assets. This introduces a level of risk in that if the markets take an unforeseen turn, the user might be left hanging instead of being able to utilize their assets elsewhere.

With Knox vaults, users will be able to withdraw their assets at any time. However, there’s no free lunch; if assets are withdrawn in the middle of an epoch, the user will receive ERC-721 (NFT) short tokens of the underlying asset that can then be sold to Premia’s pools to get the appropriate asset back. This means that while you’re able to withdraw at any time, you might incur a loss doing so.

Additionally, a 0.5% withdrawal fee is involved whenever assets are withdrawn. This is to discourage more active users from constantly moving around assets and to ensure the profitability of a vault.

Besides being able to withdraw short tokens from our vaults at any time, another level of flexibility is unlocked with ERC-4626 vault tokens. Tokenizing our vaults allows users to further leverage their deposits through more exotic strategies, such as collateralizing their yield-bearing positions on lending platforms. As the vault standard is an extension on ERC-20, vault tokens also provide similar basic functionality.

This interoperability provided by vault tokens is also a large contributor to the capital efficiency of our vaults.

Like I mentioned earlier, accurate pricing has been problematic for options in crypto. Pricing and execution are integral parts for generating the most lucrative and predictable yields possible for an options strategy, so this is something that we had to get just right.

A large part of getting pricing right comes from our collaboration with Premia - their on-chain volatility oracle allows us to get accurate pricing for any asset by fetching volatility surface data and applying it to an adjusted Black-Scholes model. In addition to the parameters used by the traditional Black-Scholes, Premia adds both position size and the market conditions of a given asset (supply/demand).

The second part of the solution in execution is on our end - options for our vaults are sold every epoch via Dutch auction. The auction starts at the highest perceived price and gradually & linearly decreases until reaching a price at which all options can be sold simultaneously.

The maximum and minimum price for a vault will be determined/adjusted based on implied volatility values before the auction for each epoch.

Selling via this style of auction ensures both bidders and LPs are incentivized, as buyers can bid their maximum value without the risk of overpaying, while LPs receive the best premiums possible.

Additionally, to secure the profitability of our vaults, the options cannot be sold below the minimum price determined by implied volatility values:

• If there’s not enough bids at or above the minimum price to sell all options, the auction will only be completed partially.

• If there’s no bids at or above the minimum price, the auction will be cancelled and no options will be written that epoch.

These are only security measures - it’s unlikely we’ll even see the latter happen.

Although this is a point that goes without saying in structured products, it’s still worth noting due to the following reasons.

Our vaults operate in automation: they’ll readjust pricing, deploy capital, and sell options according to market conditions. While our vaults can be hugely profitable for more active investors, they’re also an attractive choice for longer-term investors who don’t have the will or capacity to continuously reallocate capital in the ever-changing DeFi land.

For the latter demographic, it’s important to be able to provide a secure alternative to simply HODLing in a non-custodial wallet. This is precisely why we’ve put an emphasis on the predictability of our yields, and also something we’ve based design choices on. The goal was to beat HODLing, and we’ve done so by quite the wide margin according to back-end testing.

While on the topic of strategies, we’ll initially be looking for collaborations with lending protocols on Arbitrum to unlock more exotic vault strategies for our users. Besides the aforementioned flexibility for users, vault tokens also provide a wide array of opportunities for structured products.

Our vaults provide capital efficiency, real yield, flexibility for different types of investors, and composability for the wider ecosystem, while simplifying the process of generating yield through options.

Something worth mentioning, even if they’re called “Risk-Adjusted”, there’s no free pass on risk - although our vaults are designed to adjust themselves based on market conditions, inherent risk can never be entirely removed.

Do remember to never invest more than you can afford to lose. DeFi is still an industry in it’s infancy and anything can happen.

If any questions arose about the mechanics of our vaults, feel free to join our Discord and chat with us!

Knox is a DeFi options platform focused on predictable yields and risk management. With structured products, we automate complex strategies for a wide array of different users from long-term holders to active traders.

In collaboration with Premia, we achieve best-in-class options pricing and execution allowing for capital efficiency and better yields.

https://mirror.xyz/knoxvaults.eth/subscribe