Protocols
The largest DOV protocol is Ribbon Finance with the TVL (Total Value Locked) of $42 M as of 31 March 2023. The protocol has 13 vaults with the strategies of covered call, cash-secured put and principal protection with the following tokens: ETH, WBTC (wrapped BTC), SOL, AAVE, APE. Ribbon Finance charges 2% management fees and 10% performance fees. Treasury gets half of the protocol revenue while the other 50% of the protocol revenue is distributed to the holders of the governance token in the form of ETH.
Another big player in the sector is Thetanuts launched in December 2021. As of this writing, Thetanuts has 2 structured products: Thetanuts Basic and Thetanuts Stronghold. Thetanuts Basic is an ordinary structured product with the single strike and single tenor. As mentioned above, the protocol doesn’t charge any fees for this vault. The only fee that Thetanuts charges is swap fees for its another product, Thetanuts Stronghold.
Another product, Thetanuts Stronghold, is the aggregation of multiple Basic vaults. What was the reason to create Stronghold? Almost all DOV protocols sell options on Fridays which drive implied volatility and option premiums down. This in turn decreases investors’ yield. Thetanuts Stronghold attempts to solve this problem by combining different basic vaults. It doesn’t focus on a single time period but on the entire term structure. Selling options when there’s not a selling pressure by other DOV protocols makes it less likely that there will be “over-supply at a certain delta, with a specific tenor”. To participate in the Stronghold vault, users swap tokens with the indexed tokens. The protocol offers three Stronghold vaults: USDC put selling, WBTC covered call, WETH covered call.
How could DOVs be improved?
One of the issues DOVs present is the front running. A large structural option flow which can be as big as hundreds of millions of dollars at the same time of every week will result in a downward pressure in implied volatility. Implied volatility, a significant variable of option prices, is directly proportional to prices: if implied volatility is high, option price will be high too. Therefore, when almost all DOVs sell options to market makers on Friday through actions, this leads to depressed implied volatility and lower option prices which decreases return of option sellers. Weekly options on Deribit, the largest centralized crypto options and futures exchange, also expire on Friday which increases the selling pressure.
The problem is exacerbated by front runners, smart traders who know that sometime between 2:00 AM and 11:00 AM UTC on Friday, most vaults will offload their positions. To profit from this, they short volatility anticipating the drop in implied volatility before the selling auctions on Fridays. The research by TwoPrime, a digital asset management advisor, shows that for 4 to 7 hours before the auction volatility tends to decrease because “short open interest pushes premiums lower”. They reached the conclusion by analyzing Deribit Implied Volatility Index, an index of implied volatility on the two largest cryptocurrencies, BTC and ETH, options in 2022.
Some DOV protocols, such as Friktion addressed the front running by spreading selling throughout the day. As mentioned above, Thetanuts also seeks to solve the problem introducing the Stronghold vault. Yet another solution has been opening bids to users other than market makers to decentralize the process which is what Ribbon Finance did.
Another risk that DOVs can, and I think will face is the rise in volatility. Since they basically short volatility, a significant increase in volatility will result in large losses for DOVs. It has been mentioned many times that selling volatility is like picking up nickels in front of a steamroller. You gain small, steady gains but a rare, large loss one day can be fatal by eroding the profitability of the strategy over the years.
Overcrowding
As more investors deposit into option vaults, their profitability will drop. The same thing happened in stock market where option selling strategies performed worse than simply holding S&P 500 index during the last five years. The chart below is taken from Treehouse Finance. Buy-and-hold strategy return was higher than that of selling covered calls and selling put options on S&P 500 index. Systematically selling volatility without considering the risk-return profile of the trade will drive the yield lower.
Conclusion
Decentralized Option Vaults are an emerging phenomenon in DeFi space. By depositing collateral into a vault with a preset option strategy users receive yield which comes from the premiums option buyers are willing to pay. As such, DOVs provide a source of real yield. But bear in mind that selling volatility is risky. You’ll likely experience many small gains and occasional large losses. Consider this when you want to invest into a DOV.
