DEFI Option Vaults and Structured Products
I can’t pretend to be an expert in structured financial products. In fact, I studied engineering and IT. However, I find some similarities between financial engineering and software engineering. Here I am trying to share my motivations to start UpYield Finance.
What are Structured Products
In traditional markets, there is a long history of retail investors, financial institutions and corporates using structured products to fulfil specific investment objectives. Structured products are available for all asset classes, from stocks to interest-bearing investments, as well as bonds, raw materials, precious metals, currencies, real estate — and now cryptocurrencies.
Structured products are investment products linked to underlying assets, such as equities, interest rates, foreign exchange, bonds, commodities or funds, and use one or more derivative instruments, with the goal of offering attractive payoffs to investors that are differentiated from the return profile in the underlying asset itself.
Structured products can be used by investors with varying risk appetites to achieve a number of objectives, from risk mitigation to return maximisation, in bull, bear or sideways trending markets. Structured products basically convert one type of risk/reward into another.
The underlying mix of assets can be tailored to an investor’s individual needs, taking their risk profile and expectations into consideration.
Categories of Structured Products
Depending on the risk profile and investment objectives, the investor can select different types of products. Those can be classified in four categories:
Capital Protection
Those products may provide some return but their main objective is capital protection in any market conditions.
Yield Enhancement
These products offer yield while offering some downside protection
Participation
These types of structured products allow investors to take advantage of the performance of an underlying asset without over-committing capital
Leverage effect
These are the riskiest products, offering unlimited returns and unlimited risk, but the the risk is hedged.
Why structured products
DEFI really took off in the summer of 2020 (DEFI summer) and some of the original protocols defined the main categories: DEXes (Uniswap) and Lending protocols (AAVE, Compound). Multiple replicas appeared and in order to compete for users they started offering incentives (for example Sushi swap) such as liquidity mining and this is how the phenomena of yield farming. Of course, there were a myriad of scams and ponzis as well.
Then many yield farming protocols appeared. The problem is that none of those yields were sustainable and soon all the opportunities were gone (there is no free money). At the same time crypto derivative trading volumes have soared to levels higher than in spot markets. What structured products can offer is real, sustainable yield, extracted from market volatility or as we explain above offer alternative risk/reward profiles to investors. The first decentralised option vaults (DOV) protocols have appeared and they can be extended to implement well known structured products from TradFI or new blockchain specific ones.
Decentralised Option Vaults
A decentralised vault is a smart contract that manages client funds. Vault users can deposit funds into the vault and they receive share tokens in return that play the role of vault shares. Vaults have infinite lifespan and users can deposit and withdraw funds at any time. However, funds need to be locked for specific periods of time, typically a week for options-based products. Those funds are used as collateral for the trading strategy implemented by the vault. Trading profits accrue over time in the vault and the value of the token share is re-calculated with each weekly cycle. When users withdraw from a vault, they convert their vault tokens back to the original asset based on the latest vault token price.
The beauty of DOVs lies in its simplicity. Investors simply ‘stake’ their assets into vaults which deploy the assets into options strategies. Before DOVs, option strategies were only available to accredited investors through over-the-counter (OTC) trading or by self-execution on option exchanges like Deribit.
The strategies deployed thus far have been vanilla covered call and cash-covered put strategies which provide the highest base yield available in Defi (averagely 15–50%). On top of that, token rewards are distributed, providing an even higher yield for users.
According to QCP Capital, DOVs offer three advantages:
- DOVs bring high organic yield to Defi
- DOVs allow for scalable trading of non-linear instruments on Defi
- DOVs will be the cornerstone liquidity for Altcoin option markets
DOVs + Structured Products
DOVs can be used to implement structured products in a number of ways. Existing DOVs provide simple strategies such as covered calls. I believe that DOVs are a perfect way to simplify and automate the sell side: investors deposit and withdraw funds with minimal lock-in periods. DOVs offer a number of advantages over traditional structured products.
First, DOVs are more transparent and auditable. All of the code that is used to manage the vault is open-source, so anyone can inspect it to ensure that it is fair and honest. This is in contrast to traditional structured products, which are often opaque and difficult to audit.
Second, DOVs are more accessible to a wider range of investors. Traditional structured products typically require large minimum investments, which can be prohibitive for many investors. DOVs, on the other hand, typically have much lower minimum investments, making them more accessible to a wider range of investors.
Third, DOVs are more efficient. Traditional structured products often have high trading fees, which can eat into investor profits. DOVs, on the other hand, typically have much lower trading fees, which can lead to higher returns for investors.
Who could use Structured Product Vaults?
Retail investors: They may be interested in generating yield or protecting their capital, and they may be looking for a way to do so without having to manage their own investments.
Institutional investors: They can be hedge funds, family offices, and pension funds. They may be looking to gain exposure to crypto markets, and they may be looking for a way to do so in a way that is compliant with their investment policies.
Crypto exchanges, Apps and Wallets: They may be interested in using DOVs to generate yield on their assets or to protect their capital from market volatility.
DeFi protocols: They may integrate with the vaults in order to offer other products
DAO Treasuries: They can use the vaults to protect their funds or gain some yield.
Here are two examples on how these DOVs could be used:
- If you’re a project sitting on a treasury full of non-stable crypto with a cost base in fiat and stable, you are loving your life if ETH moons, and scraping change from the back of the sofa if it collapses. That looks an awful lot like long ETH with an overlay of long ETH calls.
- If you’re a longer term asset manager with a view to buy crypto on dips, you are currently likely sitting on USDC and leaving orders to buy crypto with a market maker or on exchange. That looks very much like you’ve constructed a short put position. Wouldn’t you rather receive a premium for that?
UpYield Finance
I am passionate about web3, DEFI, self sovereignty, financial inclusion. Being able to transact freely and preserve value are great features of Bitcoin. Ethereum made the idea of Smart Contract Popular. With Smart Contracts, you can build your own digital assets and derivative contracts. This is prime use case for smart contracts. However, current DEFI products are mainly DEXes and lending protocols, alongside many projects that are scams or offer low value. The DEFI derivatives space is small. I believe that it is going to grow and gain more and more adoption. This is how I came up with the idea of UpYield Finance. A revenue generating protocol offering decentralised structured products based on vaults, a concept that was made popular by yearn.finance.
References
An Introduction to Structured Products
An Explanation of DeFi Options Vaults (DOVs)
The State of the Crypto Options Block Market — Paradigm Institutional Insights 2023
