Friktion was one of the best passive income protocols in entire DeFi. It's pity that theys shut down it.
One of my first articles on DeFi was about Friktion.
Volt #1: Generate Income
In this article, I will explain how options work. We will look at some ways how we can generate yield even when the crypto markets fall. We’ll analyze an option strategy, selling covered calls on Friktion.
Friktion is a crypto-asset portfolio management platform, built to perform across market cycles. As of writing (29th July), the protocol TVL is $50.7 M. Native structured products on Friktion are called Volts. They are passive strategies designed to generate return across different market cycles. One of the Volts is writing covered calls to earn income.
To understand how our strategy of selling calls works, I should explain what a call option is. A call option is a derivatives contract which gives to the buyer of the option the right, but not the obligation, to buy the financial instrument at fixed price prior to expiration date. This fixed price is defined as a strike price of the option. The seller has an obligation to sell the asset to the buyer if the latter decides to exercise the option contract. For doing this, the seller collects the purchase price of the contract which is also referred as option premium.
An example will hopefully make things clearer. Say, you sell BTC call option with strike price of $30,000 and with an expiration date of 30th September, 2022 for $100. If before the expiration date of the contract, Bitcoin price ends above $30 K, the option will not be exercised and you earn $100. On the other hand, if BTC rises above $30 K, say $32,000, before the maturity date, you will lose $2,000.
Now, how can you trade this strategy on Friktion? Let’s say you have 1 SOL. During bear market you want to put your asset to use to generate yield on your Solana. SOL price is $42 right now. You sell $48 call option for $5.
Volt #2: Sustainable stables
The Volt #2 runs an automated cash secured put strategy. A trader sells an out-of-money put option on the underlying asset, but he also has to hold enough cash to buy the underlying asset if the asset price falls to the strike price and the option is exercised. You collect premium from the buyer of the option for selling him the right to sell the underlying asset to you at the price set in advance.
This Volt (actually all Volts on Friktion at the moment) are cash-settled which means that your funds will not be employed to buy back the underlying.
As of this writing, Friktion supports BTC, ETH, SOL, and MNGO as underlying assets; the stablecoins supported by the protocol (the cash you should hold) are USDC, PAI, and UXD.
By selling a put you’re betting on the asset price not to dip below the strike price. Therefore, this strategy works in bull markets but can experience big loss in violent downward moves. Like all trading strategies shorting volatility, cash-covered put selling also exhibits negative skewness. It means that you can expect frequent small gains and occasional large losses. Below I paste just a part of Volt’s historical performance to show you that this is the case.
Volt#03: Crab Strategy
This strategy is more complex than the two mentioned above. Since it isn’t a directional bet on the price move, it performs best in sideways markets. The strategy collects premia by shorting volatility. It involves shorting Power Perpetuals while hedging price risk with normal perpetuals. For the last sentence to make sense, we should understand funding rates, (ordinary) perpetuals, and power perpetuals.
Perpetual futures are like traditional futures with one important difference: they don’t have an expiration date. You can hold your position without thinking about maturity date and delivery. That perpetuals don’t expire means that there should be a mechanism ensuring that perpetuals prices won’t diverge from the prices of underlying assets. This is where funding rate enters the play. Funding rate helps perpetual price converge to the price of the underlying asset.
The prices of a perpetual contract and of the underlying asset are called mark and index respectively. If the perpetual is trading at a premium to the index (i.e., perpetual price is higher than the underlying asset price), to hold the perpetual is better than to hold the coin itself. That’s why longs will pay short an amount that corresponds to the divergence of the mark from the index. This is also called a positive funding rate. Conversely, a negative positive rate is something that shorts owe longs. This happens when the mark is trading lower than the index.
Let’s say, ETH price is $1,700 while ETH-PERP is trading at $1,710 currently. The perpetual is trading at a discount the index which means that there is a positive funding rate of 0.59%. ( (1710–1700) / 1700 )
If the dislocation of the mark from index price lasts too long, the arbitrageurs can exploit it by taking opposite positions in the perpetual and the underlying asset. In this example, a trader could short ETH-PERP and buy ETH. The sell pressure on the overvalued (expensive) asset and the buy pressure on the undervalued (cheap) asset will cause the prices to converge. Thus, the trader will earn the funding rate on (almost) the risk-free trade.
Funding rates are determined by the market. If traders are more inclined to be leveraged on the long side, then there will be a demand for buying the perpetual contract. This implies that the mark (perpetual’s price) will trade at a premium to the index (the underlying asset price) which cause the funding rate to be positive. Conversely, the demand to be leveraged short will cause the perpetual to trade at a discount to the underlying asset. Thus, the funding rate will be negative.
Now that we understand funding rates and normal perpetuals, let’s take a look at power perpetuals. Power perpetuals track the price of the underlying asset raised to a power. For example, SOL2 simply is the power perpetual whose underlying is SOL price squared.
The main reason to trade power perpetuals instead of ordinary perpetuals is that they exhibit option-like characteristics. Mathematics will make it clear. The value of the normal assets can be written as (1+r) where r is the return in percent. However, return on the power perpetual squared will be (1+r)2 = r2 + 2r +1. You can think of the power-2 perpetual as a 2X levered normal perpetual because of this 2r.
Let’s look at concrete numbers to fully understand the concept. Say you purchased $1,000 SOL. It will be worth $1,000 * (1 + 10%) = $1,100 if SOL price goes up 10%. If you hold a normal perpetual, SOL-PERP, your return will be unsurprisingly 10%. However, if would’ve bought Power-2 Perp on SOL, your gain would be (1+10%)2–1 = 21%. On the other hand, if SOL price falls by 10%, the value of the power perpetual will be (1–10%)2–1 = -19%. So, when SOL price goes up by 10%, your gain is 21%; but if the price decreases at the same rate, you lose not 21% but 19%. This is what we mean by “option-like characteristics” of the power perpetuals. If power is greater than 1, longs get an asymmetric upside which increases the for going long the power perpetual. That’s why the power-2 perpetuals almost always will trade at a premium to the underlying asset price squared (e.g., BTC2 perpetual mark price will be higher than the index price of BTC2). And this means that power perpetuals with the power > 1 will almost always have a positive funding rate.
Power-2 perpetuals (or all perpetuals with the power > 1 for that matter) should trade at a premium to the index price. Why? Because if you could buy SOL2-PERP at the index price and then short SOL 2X (levered SOL), your return would be:
(1+r)2 — (1+2r) = 1 + 2r + r2–2r — 1 = r2
We know that r2 is always positive if r > 0 so there’s an arbitrage opportunity in holding SOL2-PERP and shorting SOL 2X. That’s why the power perpetual will practically always trade higher than the index price. And this in turn means that SOL2-PERP will have a positive funding rate as already mentioned above. We know that a positive funding rate translates into longs paying funding shorts to get the convex payoff of the power perpetual. Shorts receive premia by shorting volatility and taking the risk of asymmetric payoff against them.
That’s the idea behind Volt#3. Since power perpetuals have a positive funding rate, it makes sense to short them. In order to hedge the price risk, the strategy goes long the normal perpetuals.
Volt#4: Basis Yield
This strategy is also based on collecting the funding rate. It enters the long perpetual position when the funding rate is negative. Recall that when the funding rate is negative, it is the longs who receive the funding. Therefore, the Volt enters a long position in SOL-PERP to collect the premia. But since SOL price can crash, the Volt must hedge this risk. It does so by shorting the SOL thus achieving a delta-neutral position. The strategy becomes a “direction-agnostic” bet gaining the funding rate in a negative rate environment.
Note that in a positive funding rate environment the strategy won’t work. However, as the Docs say, if the positive rates are persistent in the market, the Volt will exit the long perpetual position until the rates will revert to the sub-zero region. Another risk is an abnormal volatility which can liquidate one of the legs of this delta-neutral strategy.
Conclusion
Friktion Volts are passive income strategies designed to earn yield through various market cycles. They can be used to generate profit in bullish or bearish, volatile or range-bound markets. The first two Volts involve selling options to harvest premia; the other two Volts collect funding rates But consider the risks associated with these strategies. There are market risks, circumstances under which these Volts won’t work, and smart contract risks which almost all DeFi protocols have.
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