Decentralization Options Market Exploration: Everything is Ready, Only the East Wind is Missing

Introduction

Options, as a type of choice contract, grant the buyer the right to deliver the underlying asset under specific conditions. The emergence of smart contracts has created a favorable environment for the automated execution of options on the chain without human intervention. Since the DeFi summer of 2020, numerous teams and projects have begun to flood into the field of decentralized options. Over the past three years, the industry has shown a flourishing trend, making significant progress in areas such as accounting infrastructure, types of options, and market-making algorithms.

As the market enters a bear phase, the cost of token incentives has increased, and the activity of decentralized options has declined. With a few exceptions, innovation has largely concentrated on minor innovations in financial products. The market favors groundbreaking innovations that align with blockchain architecture and decentralized environments, such as projects like Lyra that stand on the shoulders of giants, forming a DeFi matrix and establishing a unique algorithmic system for options pricing. Despite the contraction in market size, Aevo and Lyra still hold a significant share of the top market.

Compared to the hundreds of billions of dollars in over-the-counter trading volume, the current scale of on-chain Options is still only a fraction of that. In traditional markets, the notional transaction volume of Options is basically on the same level as futures. This indicates that the on-chain Options market is still in its early stages. In the second half of 2023, as Layer 2 network technology matures, the infrastructure technology for building low-cost order book-style Options markets will drive a new round of growth in the on-chain Options market.

We have gone through the DeFi summer of “Decentralization is good,” and all decentralized projects will face the question of WHY.

01. Background of Decentralization Options

What are Options

To understand Decentralization Options, two questions need to be answered: what are Options, and why decentralize?

Options are a type of choice, where the buyer and seller agree on the exercise time and price. The holder of the option has the right to execute the contract under the agreed conditions.

As a special financial contract, options are financial instruments related to price volatility and reflect multiple dimensions such as changes in the price of the underlying asset, the rate of price change, and differences in exercise time.

Options are financial instruments related to risk pricing. The price fluctuations of options reflect price attributes that cannot be exhibited by spot and futures, providing investors with more dimensions and tools for hedging risks and designing asset portfolios.

In addition, Options have a wide range of uses. Understanding the uses of Options helps us identify the precise users of Options products. In traditional fields, besides being a leverage tool, Options have many other uses:

1. Risk Management Tools: Enterprises or projects can lock in the rights to buy and sell at a specific time and price by purchasing Options, equivalent to locking in the upper and lower limits of expenses and income, thus obtaining a minimum profit guarantee. Financial institutions can use Options to circumvent regulations. Traders can convert liquidity loss risks into fixed cost expenditures by holding Options.

2. Financing Instruments: The company can raise funds by selling Options. For example, in October 2022, Tesla raised $2.2 billion by selling 5 million call Options.

3. Organizational Incentive Tools: Many large organizations incentivize middle and senior management through Options.

4. Leverage and Speculative Tools: Investors use Options for leveraged speculation, betting on trading opportunities in dimensions such as time cost and volatility.

In 2020, with the emergence of spot DeFi, decentralized derivatives were mapped from traditional finance. The industry hopes to share the profits from the options business of centralized financial institutions through decentralized platforms.

What is Decentralization Options

Decentralization Options refer to smart contracts with options attributes that are issued on the blockchain. Compared to the traditional options market, it is permissionless, publicly transparent, and has no default risk, offering stronger combinability with other decentralized products. The execution of options is ensured by the automated execution of blockchain smart contracts, which is the only difference between decentralized options and traditional options.

Decentralization Options projects stem from the mapping of centralized options markets. In traditional financial markets, the scale of the derivatives market far exceeds that of the spot market, and the scale of the options market is comparable to that of the spot market. After successful demonstrations of the potential of smart contracts in the financial field by decentralized spot exchanges like Uniswap and Curve, many teams saw the future of decentralized futures and options. Under the halo of DeFi summer, the drawbacks of decentralization were masked, and numerous teams invested in the hot development 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. The execution environment, processes, and conditions of on-chain Options are open and transparent, with no uncertainty from a clearing perspective. How contracts are 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 bodies establish various entry barriers to prevent wrongdoing. While this protects user rights, it also objectively causes some people to lose the opportunity to participate. In decentralized options, both the smart contract creators and participants can only engage within the framework of the smart contract, without any privileges for the creators and their teams. Therefore, decentralized options are fairer.

Decentralization Options are an indispensable part of decentralized finance. DeFi is characterized by inclusiveness and convenience, and it may even reduce regulatory requirements. It has the potential to replace centralized options and also provides options services for the decentralized world.

The prosperity of the decentralized options market requires a robust development of demand for decentralized options underlying assets. Currently, on-chain options are mostly seen as gambling tools. Simple applications include using options as leverage tools or volatility underlyings, while complex applications involve becoming part of certain investment strategies, forming structured investment products.

02. Decentralization Options Market

New things and traditional things differ in many aspects. Decentralization Options differ from the traditional market in terms of underlying assets, users, channels, etc., and there is a possibility of differentiated competition.

Decentralized finance is always a data operation purely on the chain. The best targets are of course native on-chain assets. If you need to handle off-chain assets, you inevitably have to come into contact with centralized power and organizations. This belongs to the RWA business, which is subject to compliance and cannot avoid the disadvantages brought by centralization.

In addition, Options users are also different.

First of all, traditional Options users are very clear, while the target users of the Decentralization Options market are ambiguous. In traditional businesses, industrial capital is an important participant and even has a certain degree of decision-making power over the price of the underlying assets. The financial market is a bilateral market for trading risk and return, with industrial capital responsible for providing risk and risk capital. However, in the Decentralization Options market, the businesses involving underlying assets are simple and not large in scale. There are not many decentralized industries that can form real business, mainly infrastructure such as chains, oracles, data retrieval, and some DeFi projects. Taking the largest BTC as an example, the current annual output is no more than 400,000 coins, and the underlying value risk that needs to be hedged is less than 10 billion dollars. Without a robust on-chain workforce, it is difficult to form a Decentralization Options market with rigid demand.

On-chain options users should prefer programs over manual processes. The threshold for using 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 and reduce interaction between manual accounts and smart contracts.

Secondly, there are differences in compliance preferences. Centralized Options have a complete risk control and compliance system, capable of accommodating various legally defined qualified investors, while Decentralization Options have an incomplete compliance and risk control system, engaging in businesses not expressly prohibited by law, attracting individuals with low compliance requirements.

Third, decentralized options allow for more underlying options. The high volatility of digital crypto assets leads to expensive options prices. Many digital crypto assets are not legally regulated, have a high concentration of holdings, and the risk of price manipulation is difficult to estimate. Therefore, centralized exchanges find it challenging to expand the options business for digital crypto assets. Aside from some stablecoins, ETH, and 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 compete with the centralized options market in a differentiated manner.

Fourth, due to the high difficulty of product use, high thresholds, and significant compliance risks, even though many projects adopt 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 the one hand, reduce the exercise price and the range of exercise times for Options. Opyn has even created perpetual Options, further concentrating liquidity.

Fifth, although decentralized exchanges achieve no default risk through smart contracts, this no-default condition requires that the asset value controlled by the contract is higher than the loss risk faced by options. The collateral in the contract is in an over-collateralized state, and the capital utilization efficiency is generally low.

03. Bottlenecks in the Development of Decentralization Options Market

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

High cost

One of the biggest bottlenecks is the high cost of using decentralized options markets, which is caused by various factors including operational expenses, risk costs, and educational costs.

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

Risk cost is another factor that leads to high usage costs in the Decentralization Options market. As a relatively new industry, decentralized options lack sufficient historical practice compared to traditional options markets. In terms of technology and design framework, we cannot use inductive reasoning to prove that this system is sufficiently secure. The potential risk cost is the gap for large-scale adoption.

Education costs are also one of the factors leading to high usage costs. The decentralized options market is complex and difficult to understand. Users need to fully understand how it works in order to use it effectively, which could be a barrier to entry for some users.

The market is immature.

Another bottleneck is the immaturity of the decentralized options market. This not only means that there is greater risk compared to traditional options markets, but as mentioned earlier, there has not been a formation of stable and necessary demand. This may lead to difficulties in finding buyers and sellers of options, resulting in insufficient liquidity. Insufficient liquidity must be gathered by reducing the choices of participants, which in turn causes inconvenience in trading.

The immaturity of the market is also reflected in the use of Options. Traditional Options usually have multiple functions, whereas in Decentralization Options, there is a lack of demand for Options based on compliance requirements (. Traditional institutions tend to bypass regulations through derivatives ); there have been no projects that utilize Options for financing or incentive purposes; the design of Options for hedging business risks is also not as mature as in traditional financial markets.

Low capital efficiency

Another bottleneck is the low capital utilization rate of options margin. In traditional financial markets, platforms allow users to have a certain margin risk exposure. This is based on centralized credit, where the platform holds user information and can pursue users when derivatives experience liquidation. However, in the decentralized options market, users are in a semi-anonymous state, and the platform has no pursuit function. Once the margin cannot cover trading losses, the losses must be borne by the platform.

On centralized trading platforms, all user assets are managed by the platform, and non-monetary assets can also be used as collateral for credit. In contrast, current decentralized platforms require ownership of the assets to be transferred before they can be used as collateral.

Decentralized platforms cannot pursue users for excessive losses, so they must reduce the risk of liquidation. Increasing the risk margin ratio or raising the options risk fees is a reluctant measure.

The infrastructure is immature.

Decentralization Options Market