In traditional finance, the derivatives market is estimated to contain over twenty times the volume of the spot market. Compare this ratio to crypto, where derivative volume equates to roughly fifty percent of the spot volume traded. What these numbers mean is for every dollar traded on spot Tradfi markets, over twenty dollars are traded on derivative markets. Whereas in crypto, for every dollar traded on spot, a mere fifty cents are traded on derivatives. These figures show a massive discrepancy between crypto and traditional finance in this aspect, as well as huge potential for growth in the options sector of crypto. Of course, this assumes we expect this gap in ratios to close, and there are multiple strong arguments for why it will.
To start, crypto has always been building financial infrastructure that to some extent mirrors what currently exists in traditional finance. Two of the largest pieces are borrowing and lending markets, as well as exchanges for currencies, bonds, and more. In the past year, we have seen an explosion of growth when these pieces of infrastructure have been successfully deployed within crypto. Aave is a phenomenal example of this: a borrowing and lending protocol on Ethereum, which reached nearly $8 billion in market cap at its peak, and is still holding nearly a $3 billion market capitalization and a little over $13 billion in TVL, they enjoyed enormous success after launch due to providing an integral piece of a financial ecosystem. Aave was not the only valuable addition to infrastructure to experience a boom. Uniswap, a now well known swapping protocol on Ethereum, experienced growth at a similar time, rising to a $22 billion market capitalization at its peak, and today still holding nearly a $5 billion market capitalization and over $7 billion in TVL. Both of these protocols delivered a high quality, and greatly needed product for the financial ecosystem within crypto, which netted them massive growth. If options protocols are also able to deliver high caliber products, they would undergo similar aggressive growth.
As we have seen over the past few years, institutional investors are becoming increasingly interested in crypto, and are looking for ways to safely enter the market and bridge some of their strategies over to the crypto markets. Options will be an integral part of the institutional portfolio as they are often used to hedge long term investments and to access leverage in a capital efficient manner. When the firm or fund believes a short term downturn is coming but are hesitant to liquidate spot holdings, or if they simply want “insurance” of sorts, they will purchase options inverse to their spot holdings. When options protocols are able to provide a product that institutions feel secure utilizing, the top protocols would see a massive influx of volume and demand for their product. Granted, this expansion also hinges on options protocols being able to deliver, and options protocols have many hurdles to climb.
The largest challenges that options protocols have to overcome before being widely used and trusted lie in the pricing models and liquidity depth. One of the traditional finance models for pricing options is the Black-Scholes model, which works very well for pricing derivatives in traditional markets. Unfortunately, porting it on chain and using it to constantly update options prices between multiple assets and pools would incur massive, unsustainable gas fees due to the complexity of the Black-Scholes model. This issue leaves protocols with a few options: they can launch on a layer two in order to significantly decrease gas fees, do the calculations for pricing off chain and use oracles to relay the prices, or use a more gas efficient formula for pricing. Dopex and Premia have both taken the first route and found substantial success, the protocols use a formula very similar to the Black-Scholes and operate on Arbitrum, a popular Ethereum L2. Dopex and Premia currently stand as some of the leading options protocols in the space, and seeing as they effectively operate traditional options on chain, they could stand to see the most growth from an inflow of institutional capital.
Other protocols, such as Opyn have taken a different route and developed an innovative new type of option with no need for a complex Black-Scholes style formula. Opyn’s most recent product is Squeeth, a first of its kind “power perpetual.” Squeeth represents squared ETH, the price of the purchasable Squeeth asset being a fraction of the current ETH price squared, with funding subtracted. Being a perpetual option, instead of a traditional call or put option, funding must be paid in order to hold the position, just like when holding a perp position on a CEX. The difference with Squeeth, is that the funding is coded directly into the Squeeth asset contract, meaning the asset is constantly updating its funding rate based on market conditions, and reflecting the price of funding in the final price of Squeeth. While this product may not fit the demands of institutional investors as much as traditional options, the innovation coming from the world of options can be seen as another case for growth, and the new products are fascinating.
Antimatter is another protocol moving away from Black-Scholes pricing, as well as oracles all together. They cite oracles as a weak point in pricing, specifically in the area that a pricing lag or delay can be exploited for arbitrage and give a trader a worse, or “unfair” price for the option they are purchasing. This issue specifically arises when protocols are using oracles to provide pricing. For example, using a Black-Scholes formula off chain and delivering the Black-Scholes derived price via oracle, is gas efficient but potentially exploitable. Antimatter aims to create a pricing formula derived from base price of the asset, as well as demand on either side for the assest. Without getting deep into the weeds of implementation, the idea is that if an option is over-demanded, its price will reflect that due to a demand variable in Antimatter’s pricing algorithm. The inverse of the option will then become under-demanded, making it more lucrative to obtain for holding or arbitrage. This functionality is designed to balance the demand between put and call options, in order to assuage over pricing of options in times of high demand, and arrive at the “true” price for the option. Antimatter launched recently and it may be a protocol to watch in the ever expanding derivatives market.
Who will take the lion’s share of the derivatives market remains uncertain, as with most markets within crypto, but there are a few key things to keep in mind. Liquidity depth in options pools is extremely important to keeping stable pricing when writing options, so you may want to keep an eye on which protocols are attracting and keeping the most liquidity. Innovation is another component to watch, while porting TradFi systems to crypto will produce key structural pillars that will likely perform well; exciting new products, Squeeth being a good example thus far, could capture a large share of the market as well.
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Sources:
https://jumpcrypto.com/state-of-crypto-derivatives-market/
https://docs.antimatter.finance/
https://www.coingecko.com/en/coins/aave
https://www.coingecko.com/en/coins/uniswap
https://opyn.gitbook.io/squeeth/resources/squeeth-faq
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In traditional finance, the derivatives market is estimated to contain over twenty times the volume of the spot market. Compare this ratio to crypto, where derivative volume equates to roughly fifty percent of the spot volume traded. What these numbers mean is for every dollar traded on spot Tradfi markets, over twenty dollars are traded on derivative markets. Whereas in crypto, for every dollar traded on spot, a mere fifty cents are traded on derivatives. These figures show a massive discrepancy between crypto and traditional finance in this aspect, as well as huge potential for growth in the options sector of crypto. Of course, this assumes we expect this gap in ratios to close, and there are multiple strong arguments for why it will.
To start, crypto has always been building financial infrastructure that to some extent mirrors what currently exists in traditional finance. Two of the largest pieces are borrowing and lending markets, as well as exchanges for currencies, bonds, and more. In the past year, we have seen an explosion of growth when these pieces of infrastructure have been successfully deployed within crypto. Aave is a phenomenal example of this: a borrowing and lending protocol on Ethereum, which reached nearly $8 billion in market cap at its peak, and is still holding nearly a $3 billion market capitalization and a little over $13 billion in TVL, they enjoyed enormous success after launch due to providing an integral piece of a financial ecosystem. Aave was not the only valuable addition to infrastructure to experience a boom. Uniswap, a now well known swapping protocol on Ethereum, experienced growth at a similar time, rising to a $22 billion market capitalization at its peak, and today still holding nearly a $5 billion market capitalization and over $7 billion in TVL. Both of these protocols delivered a high quality, and greatly needed product for the financial ecosystem within crypto, which netted them massive growth. If options protocols are also able to deliver high caliber products, they would undergo similar aggressive growth.
As we have seen over the past few years, institutional investors are becoming increasingly interested in crypto, and are looking for ways to safely enter the market and bridge some of their strategies over to the crypto markets. Options will be an integral part of the institutional portfolio as they are often used to hedge long term investments and to access leverage in a capital efficient manner. When the firm or fund believes a short term downturn is coming but are hesitant to liquidate spot holdings, or if they simply want “insurance” of sorts, they will purchase options inverse to their spot holdings. When options protocols are able to provide a product that institutions feel secure utilizing, the top protocols would see a massive influx of volume and demand for their product. Granted, this expansion also hinges on options protocols being able to deliver, and options protocols have many hurdles to climb.
The largest challenges that options protocols have to overcome before being widely used and trusted lie in the pricing models and liquidity depth. One of the traditional finance models for pricing options is the Black-Scholes model, which works very well for pricing derivatives in traditional markets. Unfortunately, porting it on chain and using it to constantly update options prices between multiple assets and pools would incur massive, unsustainable gas fees due to the complexity of the Black-Scholes model. This issue leaves protocols with a few options: they can launch on a layer two in order to significantly decrease gas fees, do the calculations for pricing off chain and use oracles to relay the prices, or use a more gas efficient formula for pricing. Dopex and Premia have both taken the first route and found substantial success, the protocols use a formula very similar to the Black-Scholes and operate on Arbitrum, a popular Ethereum L2. Dopex and Premia currently stand as some of the leading options protocols in the space, and seeing as they effectively operate traditional options on chain, they could stand to see the most growth from an inflow of institutional capital.
Other protocols, such as Opyn have taken a different route and developed an innovative new type of option with no need for a complex Black-Scholes style formula. Opyn’s most recent product is Squeeth, a first of its kind “power perpetual.” Squeeth represents squared ETH, the price of the purchasable Squeeth asset being a fraction of the current ETH price squared, with funding subtracted. Being a perpetual option, instead of a traditional call or put option, funding must be paid in order to hold the position, just like when holding a perp position on a CEX. The difference with Squeeth, is that the funding is coded directly into the Squeeth asset contract, meaning the asset is constantly updating its funding rate based on market conditions, and reflecting the price of funding in the final price of Squeeth. While this product may not fit the demands of institutional investors as much as traditional options, the innovation coming from the world of options can be seen as another case for growth, and the new products are fascinating.
Antimatter is another protocol moving away from Black-Scholes pricing, as well as oracles all together. They cite oracles as a weak point in pricing, specifically in the area that a pricing lag or delay can be exploited for arbitrage and give a trader a worse, or “unfair” price for the option they are purchasing. This issue specifically arises when protocols are using oracles to provide pricing. For example, using a Black-Scholes formula off chain and delivering the Black-Scholes derived price via oracle, is gas efficient but potentially exploitable. Antimatter aims to create a pricing formula derived from base price of the asset, as well as demand on either side for the assest. Without getting deep into the weeds of implementation, the idea is that if an option is over-demanded, its price will reflect that due to a demand variable in Antimatter’s pricing algorithm. The inverse of the option will then become under-demanded, making it more lucrative to obtain for holding or arbitrage. This functionality is designed to balance the demand between put and call options, in order to assuage over pricing of options in times of high demand, and arrive at the “true” price for the option. Antimatter launched recently and it may be a protocol to watch in the ever expanding derivatives market.
Who will take the lion’s share of the derivatives market remains uncertain, as with most markets within crypto, but there are a few key things to keep in mind. Liquidity depth in options pools is extremely important to keeping stable pricing when writing options, so you may want to keep an eye on which protocols are attracting and keeping the most liquidity. Innovation is another component to watch, while porting TradFi systems to crypto will produce key structural pillars that will likely perform well; exciting new products, Squeeth being a good example thus far, could capture a large share of the market as well.
** **
Sources:
https://jumpcrypto.com/state-of-crypto-derivatives-market/
https://docs.antimatter.finance/
https://www.coingecko.com/en/coins/aave
https://www.coingecko.com/en/coins/uniswap
https://opyn.gitbook.io/squeeth/resources/squeeth-faq
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