Exploring Decentralization Options: Everything is Ready, Just Waiting for the Right Moment

Preface

Options are a type of choice, a rights contract agreed upon by both parties regarding delivery conditions and types of goods. The emergence of smart contracts allows contracts to be automatically executed in a chain environment without human intervention, with clear and transparent conditions and processes for contract execution, creating a favorable environment for the operation of options. Since the DeFi summer of 2020, countless teams and projects have begun to venture into decentralized options. Three years later, the industry’s development has once shown a flourishing scene, with significant progress in accounting infrastructure, types of options, and market-making algorithms.

As the market enters a bear phase, the cost of token incentives is increasingly rising. The inflated activity of decentralized options has begun to decline. With a few exceptions, innovation is focused on micro-innovations of financial products. The market rewards breakthrough innovations that align with blockchain architecture and decentralized environments; projects like Lyra, which stand on the shoulders of giants, have formed a DeFi matrix and created a unique algorithmic system for options pricing. Although the market size is shrinking, Aevo and Lyra occupy an absolute leading market share.

Compared to the off-chain trading volume of hundreds of billions of dollars, the current scale of on-chain Options is barely a fraction. In traditional markets, the notional trading volume of Options is basically on the same level as futures. From this data, we can conclude that the on-chain Options market is in its early stages. In the second half of 2023, the technology of Layer 2 networks gradually matured, and the low-cost infrastructure technology supporting the order book-based Options market led to a new growth explosion in the on-chain Options market.

We have long passed the “Decentralization is good” DeFi summer, and all decentralization will be questioned: WHY!

01. Background of Decentralization Options

What are Options

To understand Decentralization Options, two questions must be addressed: what are Options, and why decentralize?

We simply explain that Options are a type of choice, where both the buyer and seller determine the time and price of exercising the option. The holder of the option has the right to execute the contract as agreed.

Options are a type of special financial contract and also a financial instrument related to price fluctuations. Analyzing solely from the nature, options not only reflect the price changes of the underlying asset but also reflect the rate of price changes, the differences in exercise times, and so on.

Options are a financial instrument related to risk pricing. The changes in option prices can reflect price attributes that spot and futures cannot express, providing investors with more dimensions and tools for hedging risks and designing asset portfolios.

In addition, the uses of Options are extensive. Understanding the uses of Options helps us identify the precise users of Options products. In the traditional world, Options have many uses besides serving as leverage tools:

1. Risk Management Tools

Options are a risk management tool that can be discussed from both business and compliance dimensions. Enterprises or projects are constantly facing fluctuations in the prices of raw materials and products. In addition to using futures to lock in costs and revenues in advance, they can also purchase options to obtain the right to buy or sell at a specified price within a specified time. This is equivalent to locking in the upper and lower limits of expenditures and revenues, ensuring a minimum profit. For financial institutions, derivatives are an emerging phenomenon, with types and complexities that surpass stocks and bonds. In terms of regulatory circumvention, options often play an unexpected role. In trading, some traders hold large positions and may face significant liquidity losses when handling risk control liquidations. Therefore, holding some corresponding options during periods of low volatility can convert liquidity loss risks into fixed cost expenditures.

2. Financing Tools

In finance, options are also an important financing tool. We do not discuss convertible bonds as options + bonds. Historically, many companies have also financed themselves by selling options. In October 2022, Tesla raised 2.2 billion USD by selling 5 million call options. Options allow holders to buy Tesla stock at a price of 1100 USD in January 2024.

3. Organizational Incentive Tools

In many traditional large organizations, Options are also used to incentivize the middle and senior management. This behavior has been seen frequently in the traditional world. There are already numerous papers discussing the pros and cons of Options incentives.

4. Leverage and Speculative Tools

Many investors use Options for speculation. They leverage small capital to achieve large returns, even betting on trading opportunities based on time cost dimensions or volatility dimensions. This is a feature that many other financial instruments do not possess.

In 2020, with the implementation of spot DeFi, decentralized derivatives were mapped over from traditional finance. People hoped to share profits from centralized financial institutions’ options business on decentralized platforms. So how do we define decentralized Options?

In traditional finance, options have different circulation markets, in addition to the exchange’s over-the-counter trading, there is also the OTC market.

What is Decentralization Options

Decentralization Options refer to smart contracts with options properties issued on the blockchain. Compared to traditional options markets, they require no permission, are publicly transparent, and have no default risk, offering stronger combinability with other decentralized products. This is in contrast to traditional options on centralized exchanges or over-the-counter options. The execution of options is guaranteed by blockchain smart contracts and is executed automatically. This is the only difference between Decentralization Options and traditional options.

Decentralization Options projects arise from the mapping of centralized options markets. In traditional financial markets, the derivatives market is far larger than the spot market, where the scale of the options market is equivalent to that of the spot market. With the success of a number of decentralized spot exchanges like Uniswap and Curve, the potential of smart contracts in the financial industry has been demonstrated. Many teams have seen the future of decentralized futures and even options. Under the halo of DeFi summer, the drawbacks of decentralization have been obscured, and numerous teams have invested in the hot construction of decentralized options.

Why Decentralization Options are Important

The advantages of decentralized Options over centralized Options are mainly reflected in: 1, eliminating default risk; 2, being fairer; 3, deeper and closer capital collaboration.

Compared to centralized Options, decentralized Options have no counterparty risk. Risk is uncertainty. The execution environment, processes, and conditions of on-chain Options are open and transparent, with no uncertainty from a clearing perspective. How a contract is cleared and the results of the clearing are clear at a glance. Without uncertainty in clearing, there is no counterparty risk.

In traditional finance, regulatory authorities have established various entry thresholds to prevent wrongdoing. On one hand, this protects the rights of users, but it inevitably causes some people to lose the opportunity to participate. At the same time, whether it is the creator of the smart contract or the participants, they can only engage in the game under the smart contract, and the creators and teams do not have privileges. Therefore, Decentralization Options are fairer.

Decentralization Options are an indispensable part of Decentralized Finance. Decentralized Finance is inclusive, convenient, and can even reduce regulatory requirements. On one hand, it has the potential to replace centralized options. On the other hand, the decentralized world needs the services of options.

The prosperity of the decentralized options market requires the robust development of the demand for decentralized options underlying assets. Currently, on-chain, options are often referred to as gambling tools. A simpler way to think about it is to make options a leverage tool or a volatility underlying asset, while a more complex view is that they become part of certain investment strategies, forming structured investment products.

02. The Market of Decentralized Options

New things and traditional things have differences on many levels. Unlike traditional finance, whether from the underlying assets to users, or channels. Decentralization Options and traditional markets have differences, and there is the possibility of differentiated competition.

Decentralization finance is always a data operation purely on the chain. The best targets are of course the assets on the original chain. If there is a need to handle off-chain assets, it is inevitable to come into contact with centralized powers and organizations. This falls under the RWA business, constrained by compliance, and cannot avoid the drawbacks brought by centralization.

In addition, Options users are also different.

First of all, the users of traditional Options are very clear, while the target users of the decentralized options market are vague. In traditional businesses, industrial capital participates in the options market. Like in the futures market, industrial capital is an important player in the traditional futures options market. They even have a certain degree of decision-making power over the prices of the underlying assets. The financial market is a bilateral market for trading risk and returns, with industrial capital responsible for providing risk and risk capital. In the decentralized options market, the business involving the underlying assets is simple and the transaction volume is not large. The decentralized industries that can truly form a business are mainly infrastructure such as chains, oracles, data retrieval, and some DeFi projects. Taking BTC, the largest in scale among them, as an example, the annual production currently does not exceed 400,000, and the underlying value risk that needs to be hedged is less than 10 billion. Without robust on-chain participation, it is actually very difficult to obtain sufficient industrial demand. This leads to the fact that we have not formed a rigid demand decentralized options market.

Users of on-chain options should be more inclined towards programming rather than manual operation. The usage threshold of on-chain options is lower for programs and higher for individuals. The design of buying and selling products for on-chain options should increase interaction between smart contracts more, reducing the interaction between manual accounts and smart contracts.

Secondly, the differentiation of compliance preferences. Centralized options have a complete risk control and compliance system, able to accommodate various legally defined qualified investors, while decentralized options have incomplete compliance and risk control systems. They engage in activities that are not legally prohibited, attracting individuals with low compliance requirements.

Third, decentralized options allow for more underlying options. The volatility of underlying digital assets is high, leading to expensive option pricing. Many digital assets are not legally regulated, have high concentration of holdings, and the risk of price manipulation is difficult to estimate. Therefore, it is hard for centralized exchanges to expand the business of underlying digital assets related to cryptocurrencies. Apart from some stablecoins and ETH, BTC, it is difficult to develop suitable underlying options. However, some decentralized exchanges have designed the “private pool” concept, allowing market makers to independently bear the exercise risk of certain options, enabling the decentralized options market to differentiate itself from the centralized options market.

Fourth, due to the high difficulty of using the product, high thresholds, and significant compliance risks, even though many projects have adopted marketing strategies such as token airdrops and trading rewards, participation funds and product users remain scarce. Inactive products face the dilemma of poor liquidity. Decentralized exchanges, on one hand, reduce the exercise price of Options and the optional range of exercise time. Opyn has even created perpetual Options, further concentrating liquidity.

Fifth, although decentralized exchanges achieve no default risk through smart contracts, this no default under the smart contract requires that the value of the assets controlled by the contract is higher than the loss risk faced by the options. The insurance in the contract is in an over-collateralized state. The efficiency of fund utilization is generally low.

03, Bottlenecks in the Development of the Decentralization Options Market

The decentralized options market is an exciting new asset class, but it is still in the early stages of development. Therefore, many bottlenecks need to be addressed before its potential can be fully realized.

High cost

One of the biggest bottlenecks is the high cost of using decentralized Options markets. This is caused by multiple factors, including operational expenses, risk costs, and education costs.

The operating fee is the cost that users must pay to miners to process transactions on the blockchain. On popular blockchains like Ethereum, gas fees can be particularly high, and some projects may require oracle quotes. This may make the Decentralization Options market too expensive for certain users.

Risk costs are another factor that leads to high usage costs in the Decentralization Options market. The Decentralization Options market is a relatively new industry compared to traditional options markets.