A Tale of Crypto Structured Products - Circa 2021
The King Is Dead; Long Live the King
During the summer heat of 2021, decentralized finance applications (dApps) are at its peak of glory - new protocols are launching every week. You have a plethora of applications to park your crypto funds: automatic market makers (AMM), lending pools, perpetual futures exchanges (DEX), options protocols, and more. Collectively you can call this group of dApps “DeFi”. At its peak, the total value of assets locked (TVL) inside DeFi’s smart contracts almost reached $200 Billion. What is even more astonishing was the speed. DeFi’s Total Value Locked increased from just shy of $1B in May 2020 to about $170B in Nov 2021 - a 170x in a year and half! 1
Amongst the different applications, one area is particular interesting to me: crypto structured products. With crypto options coming on-chain via applications such as Psyoptions, Opyn (among many others), it opened up possibilities to compose these instruments together and synthesize new financial products, like legos. Now if you have spent some time on crypto twitter (CT, as it is called), you will know that the “lego” comparison is definitely over hyped in the course of 2021. But to me, it is an exciting field.
If it is not obvious: existing financial industry infrastructure is largely siloed and layered. There may be collective efforts from some industry leaders to create more or less regional technology stacks to improve communication and balancing of ledger between institutions. Overall, financial system has been built on layers simply due to its systemic importance - you cannot shut off the financial system to do a root level upgrade, even for a couple of hours. Upgrading the financial system is about adding band-aids as fixes rather than peeling off temporary fixes to build something new. Because of this, it is imaginable that financial products and services are slow, costly, and don’t “talk” to each other. This naturally gives the incumbent players little incentive to innovate.
Hence when you mention programmable, composable, and interoperable financial instruments and contracts, it has deep implications on the future of finance and the innovation that these attributes can bring.
Blockchain Option Protocols - Beginning (Early 2021)
At first there was options. Options are not new. It is believed that financial options were developed by Belgian financial exchanges as far back as the 16th century. But options on the blockchain is new and interesting. In early 2021, we have seen the birth of blockchain options protocols.
These are applications that exist as smart contracts on a blockchain that offers the buyer and seller a function (or a set of functions) to trade options for crypto assets. Although the specific implementations may differ from application to application, the underlying instrument is the same - giving a buyer the right but not the obligation to buy or sell an instrument in the future at a specific price.
Trading volume on these option protocols were not high until after the introduction of DeFi Option Vaults (“DOV”). Trading options on chain has numerous challenges. Providing liquidity for options is too capital intensive for non-professional traders. Options are inherently multidimensional - non-linear cardinality based on strike price, current underlying asset’s price, and expiry date. Combining high capital requirement with high dimensionality you get complexity. And retail users don’t like complexity.
For example:
There are over 700 different option instruments on bitcoin on Deribit exchange.
There are over 3000 different option instruments on Tesla stock traded across 8 different exchanges!
Which option should one buy? Who would be taking over the other side of the trades? When the price of the asset move, how would strike price be updated? These are difficult technical and usability trade-off questions for pure option protocols on the blockchain. As a result, we didn't see much interest for pure option protocols on the blockchain.
It was only after the introduction of something called DeFi Option Vaults (“DOV”) that these on-chain option applications saw a 10x increase in trading volumes. DOVs are the primitive crypto structured products and they have lead the growth of this category for most of 2021.
DeFi Option Vaults - Rise and Fall (Middle of 2021)
At its core, most DOVs are pools of assets stored on a smart contract that let users earn a non-guaranteed income on an asset by selling options using the asset as collateral.
Let’s say Joe has 1 Ether. The current price per Ether is $2,000. Joe would deposit the 1 Ether into a DOV smart contract. The smart contract would systematically sell 1 call option to another user such as Alice, or (more likely) a liquidity provider firm such as Bob Trading Inc. Let’s assume Alice bought the option.
The option costs Alice $100. The option has strike price of $2,200. Joe gets to keep the premium of the option ($100). Sounds like Joe can keep earning income on his Ether as long as he repeats this process. What is the catch?
This strategy is a basic covered-call strategy. If the price of Ether does not exceed $2,200 (which is the strike price), Joe will keep the premium as well as his Ether. However, if Ether rises above $2,200, Joe will give up all the gains for prices above $2,200 (Alice will capture those gains). Covered call strategy is great if you expect the price of the asset to stay the same or fall, or you deliberately say “I want to sell my Ether at $2,200 regardless of its future price movements”.
It is estimated that over 90% of all DOVs in 2021 are covered-call strategy. The product had great traction as most DeFi users has some form of assets on the blockchain. Instead of letting these assets sit idle, one can generate income on these assets by selling options. In addition to covered-call strategies, we have seen other structured products come on-chain such as the knock-in knock-out structured product application such as Cega, and some exotic products offered by Ribbon finance. Fig Investments’ predecessor was born out of this period: Sollar. The original idea was to compose multiple options together to create synthetic fixed income on the blockchain.
At its peak, DOVs exceeded $1 billion in total value locked. However, these products are not without its controversies. Many users believed that the income provided by selling options is risk-free (it’s not) and or that their assets are safe inside a DOV (not true). Attribute this to the speculative fervour or the lack of regulation, the end result is that DOV lost its appeal once the crypto bear market hit by early 2022. It’s TVL saw a 95% drop between peak and trough. Many DOV protocols exited the business entirely.
Crypto Structured Products - The Future (2022 and Beyond)
Was DeFi option vault a failed experiment? I think the answer depends on how one looks at it:
Prior to DOV, covered call is an obscure strategy that historically only sophisticated investors have access to;
It increased on-chain options trading volume by 10x;
Arguably we see crypto structured products highlight the most important use case for blockchain: the inevitable tokenization of assets.
What made DeFi option vaults possible? There are many factors. We argue the most important of which is the tokenization of options. Through tokenization, we implicitly lay the ground work for a new financial system based on a simple and imaginable building block: tokens.
With the option token standards, users and liquidity providers can bid on standardized option tokens with ease, both financially and technically. Whether it is tokens for options, tokens for stocks, the idea is that each token carries a standardized set of attributes that allows them to work together, without friction, without middleware. Assets can be verified through tally of a token’s attribute(s), increasing transparency and simplicity. Transparency reduces counterparty risk. Uniformity of asset configuration reduces cost.
What would become of financial product pricing if market friction cost is truly negligible instead of assumed negligible2 ? Market friction includes explicit dollar cost as well as implicit cost priced in credit spreads. We will have dramatically increased the design space for financial products and innovation. What if we can truly build a hyper tailored portfolio to an investor’s goals, using combinations of financial instruments that are simply not possible before? The investor would be:
They would be less likely to panic sell during market volatility, reducing emotional cost of investing, and
More likely to earn higher risk-adjusted returns,
In my opinion, the next frontier could be crypto structured products. But we think the next generation of “structured products” encompass far bigger themes:
Structured portfolios where a portfolio constructed using shallow parametrics but with upside and downside clearly defined.
Separation of income vs risk, giving investor the choice of generating income with measurable definition of risk rather than loosely defined heuristics;
Outcome based investing, whereby portfolio construction is to achieve a (set of) goal(s) instead of using goals to fit a portfolio.
All of these are possible if enough assets are tokenizable. We see almost an endless design space for new and exciting investment products in an industry that is increasingly commoditized.
Alas, the king is dead; long live the king.
Conclusion
Despite the volatility of DeFi and crypto structured products, their potential is undeniable. They've democratized sophisticated strategies and underscored the power of asset tokenization.
The vision of a future financial ecosystem, rooted in the simplicity and versatility of tokens, promises greater transparency, accessibility, and customization. Even with the fluctuations in DeFi Option Vaults, the journey towards this innovative future has only begun. The rise and fall of this early experiment serve as stepping stones in the evolution of a transformative sector - one where what is to come is set to be more powerful, resilient, and innovative than ever before.
Remember that none of the information presented on this letter and blog are investment advice or solicitation of any kind. Fig Investments currently is not offering any investment products. You should do your independent due diligence before investing money into any asset. Please see Fig Investments’ disclosures here.
“170x” sounds like a lot. Since November 2021, DeFi’s total value locked dropped by about 80% - to about $45 billion as of the time of this writing. Regardless the growth of $1b → $45b is notable.
As most financial market practitioners would say, assuming negligible market friction cost (until it is truly frictionless) is dangerous and foolish.