Inside the Vault: A closer look at DOVs
Jonathan Ng
0x56CC
June 3rd, 2022

Introduction

DeFi options have seen phenomenal growth in 2021 and now 2022, with its Total Value Locked (TVL) booming from 92 million dollars a year ago to over a billion as of May 2022.

Data from: https://defillama.com/protocols/Options (link accessed 04/10/2022)
Data from: https://defillama.com/protocols/Options (link accessed 04/10/2022)

This article introduces DeFi Option Vaults (DOVs) as a new financial innovation within the DeFi options space and examines how DOVs work and their four unique value propositions: accessibility, sustainable yield, altcoin options liquidity, and composability. The article will also take a closer look at the yield representation and performance of various protocols to date and provide some thoughts on how best to assess DOVs.

DeFi Option Vaults (DOVs) – An Overview

WHAT ARE DOVs?

DOVs made their debut in early 2021. To understand DOVs, we need to first understand the basics of how options work.

Options are contracts that give its owner the right, but not the obligation, to either buy or sell an asset at an agreed-upon price (“strike price”) by an agreed-upon time. In every option trade, there are two parties: an option writer (seller) and option buyer. The option buyer pays the option writer a premium for the rights to the contract. At the point of expiry, the option buyer can choose to exercise the option, and the option writer is obligated to fulfil it at the agreed-upon strike price.

DOVs utilize smart contracts to automate the process of selling options for its users. It provides a new source of passive yield generation by selling weekly out-of-the-money (OTM) options while distributing the option premiums to its users as yield. Due to the high volatility of crypto options (vis-a-vis traditional equity markets), the yields of some of these vaults are highly lucrative and can range from 15%-70% APY depending on the asset and market structure.

HOW DO THEY WORK?

DOVs offer options with short term expirations and typically run weekly strategies that DOV users can participate in. Protocols call each of their respective yield cycles an epoch.

Prior to the start of the weekly epoch, users can deposit assets into various vaults – which are selected based on asset type and options strategy based on their market view. Currently, DOVs offer 2 options strategies: cash-secured puts and covered calls.

  1. Cash-secured puts – suitable for neutral to bullish sentiment, where users/sellers believe the price of the asset will expire above the strike price
  2. Covered calls – suitable for a neutral to slightly bullish sentiment, where the price of the asset is on an upward trend, but users/sellers believe it will expire below the strike price

At the start of the epoch, the vaults mint option contract tokens using the collateral deposited. These options are then sold to market makers via Gnosis Auction or blind Dutch auction via Solana’s RFQ system. The premiums collected from the sale determine the yield percentage of the week.

Yield % = (total premium) / (total collateral in vault)

Before the option expiry, the assets are locked within the vault. Users can opt to withdraw their deposited assets. However, the assets are only released after the conclusion of the current epoch.

At expiry, there are 2 possible outcomes:

  1. The option expires in-the-money (ITM) – the option buyer has the right to exercise their option and the assets within the vault are used to pay off the difference between the strike price and current market price.
  2. The option expires out-of-the-money (OTM) – the option ends up worthless, and the vault depositor profits with the premiums.

Unless the assets are withdrawn, the vault automatically re-runs the strategy for the next week, compounding the returns for users over time with every successful epoch.

Part 1: DOVs’ Four Value Propositions

Unlike a typical yield farm or CeFi options, DOVs offer four unique value propositions for their users.

1. Accessibility

Options are complex financial instruments that are relatively difficult to understand. To be able to effectively select and apply the multitude of trading strategies to varying market conditions is another new level of difficulty. Typically, traders need to assess a variety of factors to successfully select a strike price that is sufficiently OTM, so that the option expires worthless, and yet close enough to the market price to maximize the premiums collected.

For most crypto users who are just seeking high returns on their investment and have no interest to acquire a deep knowledge of various financial instruments, DOVs offer a well packaged solution that abstracts the complexities typical in options, including selecting strike prices, expiry dates, etc. DOVs open the door for retail investors to access, participate and earn yield from the otherwise complex options market, which is typically dominated by sophisticated traders and institutions with abundant capital, research resources and experience.

In addition, instead of users purchasing options individually, which would translate to multiple transactions each week, the vault architecture of DOVs allows for thousands of users (and their transactions) to be aggregated and transacted together. This allows for reductions in high gas fees typically associated with multiple transactions. In addition, DOVs’ auto compounding feature allows users to skip any additional transaction costs should they want to roll over their deposited vault assets into the next epoch.

In summary, DOVs provide easy and cost-effective access and a simple, straight forward user-experience to a sophisticated financial instrument that can potentially deliver attractive yields.

2 – Sustainable Real Yield

DeFi is constantly in search of new forms of yield. Currently, a large portion of the yield in DeFi comes from token emissions – where yields are paid out as incentives to support liquidity provision or as staking rewards. However, yields from such protocols are circular and synthetic and require a steady inflow of new users and upward price action to sustain its high projected yield.

As Jordi Alexander explains in the law of thermos-ponzinomics, “An economically isolated system cannot create money — it can only redistribute what was put in”. What this means is that if we consider no new buyers—and hence no new money—entering the market, the value within the system cannot magically increase. Thus, emissions might be reframed as a form of dilution – where whilst the number of tokens one owns might be increasing, the percentage owned in relation to the overall market cap remains the same. Over time, as the dilution gets greater and assuming the price remains constant, the first person that sells is the one that is able to extract the highest proportion of the overall market cap, which will result in a more than proportionate fall in price.

Once the price of the token starts tanking, the yield percentages are similarly eroded. Users seeing falling yields would flee to other sources or forms of yield, putting further sell pressure on the token, which can potentially start a death spiral of panic selling and the ultimate collapse of the yield farm.

Another source of yield comes from money markets such as Aave or Compound. Here, users earn yield by providing assets which others want to borrow. While these yields are organic, money markets tend to suffer from the “crowding out” effect, where there is far greater demand for easy yield than there is demand for borrowing. As a result, many of these money markets can only offer low single-digit returns.

In the case of DOVs, their yields are not reliant on emissions by the protocol itself but are instead provided from external sources in the form of premiums – a fee paid by market makers for the provision of a service (in this case the option contract itself). In addition, DOVs’ yields are not affected by the “crowding out” effect, as long as there is sufficient demand from option buyers. Noting the overall size of the derivatives and options markets in TradFi and Cefi, there is plenty of runway for new entrants, both retail users and larger institutions.

3 – Altcoin Options Liquidity

The current crypto options market is largely dominated by BTC and ETH, with a majority of its volume routed through the CeFi Deribit exchange. There is an absence of any altcoin options due to the insufficient natural liquidity available to provide efficient spreads.

Excitingly, DOVs have become the largest trading volumes for altcoin options. DOVs provided the catalyst of a critical liquidity injection to kickstart the altcoin options markets. Working with market makers on the buy end, DOVs provide the supply side options liquidity via the deposited funds within their vaults. As altcoin DOVs continue to grow and market makers take on larger altcoin option positions on their books, altcoin options market will continue expanding with thicker liquidity. With greater confidence in liquid options markets, large institutions and investors can step in to partake in the speculation or yield generation, thereby kickstarting the virtuous cycle. Additionally, analogous to equity markets, the development of derivatives liquidity will inevitably have positive spillover effects to their respective spot altcoin markets.

New vaults for various asset types are constantly springing up– Ribbon finance even has a $APE vault for the recently launched Apecoin by the Bored Ape Yacht Club team. With more and more altcoin vaults offered, individuals and groups with huge collections of assets, such as investors, institutions, or DAO treasuries, will inevitably be looking to DOVs to capitalize on their assets for additional yield.

4 – Composability

DOVs are still in a nascent state and there are huge opportunities for further development in terms of the range and types of structured finance products, as well as integration into other DeFi legos within the broader crypto ecosystem.

In addition to the high organic yield which comes from collecting option premiums, DOVs can potentially allow users to plug in and collect other forms of yield as well. For example, across the week before the expiry of the option, protocols could stake the assets to earn additional staking yield. Some protocols might also have emission-based incentives to entice protocol usage, further boosting yield. Additionally, the emergence of new option vaults for productive assets such as Solend’s yield-bearing cTOKENS, Lido’s liquid-staking stTOKENS or Yearn’s yVault Tokens, allow for increased capital efficiency.

Further innovation can come in terms of new products. While most vaults currently offer only vanilla puts and calls, there are a wide range of possible strategies that could be implemented – from new option strategies or combinations of various structured products. These products can emerge to address DeFi-native use cases. For example, Dopex is reportedly launching a REDACTED vault that would allow users to bet on interest rates of curve pools. This would further incentivize participation of protocols in the Curve Wars as a new way to hedge against pool APY risks or to provide users with a new avenue to speculate and take advantage of the outcome of the Curve wars.

As DOV protocols continue to mature and more users are onboarded, more specific and exciting financial products will continue to be created to suit the ever-growing interests and needs of the community.

Part 2: While yield is yield, not all APYs are equal

APY, short for annualized percentage yield, is a familiar term that is well known throughout DeFi. It is the real rate of return of an investment accounting for compounding interest. It was popularized with the explosion of DeFi yield farming throughout 2020 and yet again in 2021, with rebasing protocols and their incredibly high APYs, the most prominent being OlympusDAO ($OHM).

DOVs similarly employ this metric of APY to highlight and compare the returns of various vaults. While the continuation of this familiar term makes it easy to onboard existing DeFi-native users, a reflection on the specific perimeters of the DOVs and the ways in which risk is calculated make this measure a complex one. Unlike rebasing protocols or emission incentives, DOVs’ APY isn’t directly controlled by the protocol. Instead, they are a result of the premiums paid, which are influenced by a variety of factors, including the strike selection, how far OTM the strike is selected, etc. For example, the closer the strike price selected vis-a-vis the current price, the higher the premiums due to their higher probability of being exercised.

Therefore, what arises is an important tradeoff that various option vaults and protocols need to make: whether to select strikes closer ITM and hence offer a higher, more attractive yield, or to select further OTM strikes for a lower return but higher probability of keeping the entire premium.

For the DeFi degen, the choice might seem obvious: always select the vaults with the highest APY across the protocols. However, looking at the historical returns of DOVs and their inherent volatility, a single exercised option contract can potentially wipe out 4-10 weeks of unexercised premiums collected. A case in point is the recent Solana covered-call vaults which expired ITM on the week ending 1st April 2022. Due to the rapid price pump, vault users saw a loss of approximately 3-4% across various vaults. In comparison, the average typical weekly yield for this vault is between 0.5-1%. As such, the risk of being exercised across any given week outweigh that of its counterpart.

This article puts forth the question: considering the mechanisms behind DOVs and the unique risks they encompass, is APY the most accurate mode of measure? Or should a new metric be considered altogether?

This section will discuss 3 additional factors which DOVs users might consider:

  1. Model of calculation
  2. Model for Selection of strike
  3. Fees Charged

1. Model of APY calculation

It’s not possible to compare something objectively if the methods in which they are calculated are different. Currently across various DOVs, there is not a single consistent way of calculation. Some protocols extrapolate the returns of a single previous epoch, resulting in highly irregular APYs that change across weeks. Others average the returns across various time periods from a month to 16 epochs, providing a steadier APY percentage. On top of this, the way in which various protocols account for options that expire ITM, differ: some count the yield as 0% (excluding the upside lost from the upside) while others exclude the ITM weeks from the APY calculation altogether. As a result, these APYs fail to account for losses and thereby project a vault APY with a higher return than its actual performance.

In addition, there are also differing opinions in the calculation of APY returns in relation to the base asset (in $ETH for an ETH vault or $SOL for a SOL vault etc.) or to their stablecoin values, which further complicate an already inconsistent calculation of true APY returns.

2. Strike selection

As articulated earlier, there is an inverse relationship between how far OTM the strikes selected are and their respective premium payout. Thus, one of the key factors to consider is how the strikes for DOVs are selected. Currently, most protocols target options with a range of 10 to 15 delta, which reflects an OTM option which has approximately a 10-15% chance of being exercised.

In his article, Sam Chepal backtested this 10 delta covered call strategy for both Ethereum’s and Solana’s historical prices. He noted for Ethereum that “this strategy faced a significant loss in early 2021… although these major shocks tend to be infrequent… just a handful of exceptional tail-events are the primary root cause for the significant underperformance of this strategy”. He also saw similarly significant losses in the case of Solana as compared to just holding spot.

Annotation in green by author. Original Image from: https://www.samchepal.com/a-quantitative-analysis-of-defi-option-vault-strategies/
Annotation in green by author. Original Image from: https://www.samchepal.com/a-quantitative-analysis-of-defi-option-vault-strategies/

However, while Chepal’s analysis might indicate an ineffectiveness of selling options for yield, it is important to note that the study was conducted when Ethereum and Solana were in their early emergent phase. Protocols in their early phases, tend to face greater price movements due to surges of new market entrants and hence might account for the volatility and losses in the covered call strategy. It is important to note that DOVs emerged in the middle to late part of 2021. Hence if we constraint the period of Chepal’s ETH covered call study above (as indicated in the green box in the chart above), despite several small dips of options expiring ITM, we see that the strategy overall has been on a positive uptrend.

As DOVs continue to mature and with more data points available, I believe we will see different vaults further tailoring their strategies to fully account for the specificity of the different assets over a universal strike selections strategy. For users, beyond just chasing the highest APYs, this means selecting a protocol and vault strategy which best aligns with one’s overall risk tolerance and yield objectives.

3. Fees Charged

Hedge funds that are actively managed typically carry a “2/20” fee structure - a 2% management charge on assets under management (AUM) and a 20% profit performance fee. DOVs protocols such as Ribbon Finance, Frikton or PsyFinance have adopted this model and carry a similar 10% performance fee on the premiums collected. For these protocols that charge fees, users should ensure that the APY reflected takes into consideration these fees as they impact the net APY.

In the table below, we compare 3 different APRs (which exclude compounding) and the effects of the various fees on the final APY. Note that for this analysis, we assume that the yield is maximized with all weeks expiring OTM, thus giving a compounding period of 52 weeks.

Currently, these fee percentages feel exceedingly high considering that these DOVs are only running vanilla covered calls or puts at one-week expiry. Many protocols work off a basis of a specific strike selection criterion based on a specific delta range, which does not require any active trading or propriety strategies.

These fees present an asymmetrical risk for users, where their yields are reduced and at the same time, they carry the entire investment risk. As a comparison, hedge funds which charge fees have mechanisms such as claw-back or high-water mark to ensure that their performance is aligned to investors’ interests.  Given the “vanilla nature” of current DOVs, instead of adopting the hedge funds fee model, perhaps a more equitable fee model for comparison is to robo-advisors, which on average have charged relatively much lower fees of 0-0.5% AUM.

Ultimately, no one is sure what is the appropriate fee percentage to be charged or if they should be charged at all. Yet, it would be naïve to underestimate the importance of good fund managers for the health of the vaults. Thus, DOVs must balance the long-term sustainability of the protocol – to incentivize continuous development of new DeFi structured products while offering attractive returns for its users.

What is the correct measure?

DOVs fundamentally need a different set of metrics for comparison due to their nature and risk profile. Creating a consistent method of APY calculation across protocols might be the first step in making the representation of the DOV yields more transparent and accurate.

One possible solution for APY calculations might be the use of a time-weighted historical average, including losses, across a fixed period (for instance, 3 months or 6 months), before being extrapolated to a year. The period should be sufficiently long to ensure the calculations reflect a consistency of yield returns. The time-weighted factor would better reflect the present yield return due to current market conditions while safeguarding against singular black-swan events which might excessively skew the APY calculations, disincentivizing new vault entrants. Newer vaults with a less established track record, i.e. shorter than the set period, might indicate this to users on their APYs reflected (for example with an asterisk beside).  The end goal to create a universally understood and measurable means of comparing yield results, which would allow users to make better informed decisions and protocols to better showcase their unique features and performance.

Conclusions

DOVs are a remarkable financial innovation, with their unique value propositions of increased accessibility for retail, sustainable real yield, creation of expanding DeFi options liquidity and composability. They hold great potential to completely change the DeFi Options landscape as the de facto source of yield if they can address the gaps and concerns regarding APY calculation, strike selections and management fees.

With aggregated daily open interest for Bitcoin and Ethereum options within CeFi markets at approximately 7 billion and 5 billion respectively, there is a massive runway for growth for the DeFi options space if they are able to claim a similar market share. With new features, tools and integrations coming out each week, there is no question that DOVs already possess all the necessary tools to continue leading the charge in the development of this space, while onboarding the next wave of new users seeking to speculate and earn yield from the DeFi options market.


About the author: Jonathan Ng is a creative technologist and designer working at the intersection of web3, architecture and computational fabrication. His research looks at how new digital paradigms, systems and tools reshape our experiences and interactions within cities.

Special thanks to Ayush Menon for his guidance and thoughtful feedback in the process of producing this piece.

Disclaimer: Harvard Blockchain and the author of this piece are not financial advisors. Nothing contained in this research piece should be construed as investment advice.

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