Demystifying Options in DeFi: A Deep Dive by Panoptic | ETHDenver 2023

Okay. Hello everybody. Um, we want to thank um, ETH Denver first for the invitation to come speak here. I'm Jesper. I'm with Panoptic and we're super excited to talk to you about the derivatives infrastructure for the frontier of DeFi.

So, in 20 minutes, my expectation is that your understanding of how to best do derivatives in DeFi will have changed. In fact, let's just start by discussing the four pillars that are necessary for a healthy financial ecosystem. So, this would obviously apply to DeFi as well. We have fixed income which can give you stable predictable yields. So, bonds and notes would be examples.

Then we have equities that can represent ownership and trading. So, you know, Tesla, Coinbase, etc. and then futures where you can make directional trades. Um you can use it to do simple hedging and they're capital efficient. So this provides an important pillar as well.

So examples are commodities, oil, S&P 500 index. And then finally and most maybe uh I don't know one of the most impactful things for sure is options, right? So with options, they're a little bit of a meta pillar like bigger than the other pillars in the sense that you can actually build options on all the previous pillars we talked about and thus increase the capital efficiency. So they're even more capital efficient. You can do even more complex hedging and of course risk diversification.

So you know you can bet on things like the VIX but also um you know volatility basically and you can also again as mentioned build options on top of the pre-existing pillars. So, it's very important to have and you know if we look at options in crypto right now um we're in a little bit of a a tough spot I would say uh when it comes to DeFi you know the majority of options are traded on centralized exchanges so in particular derivit only very few offerings are available so you know bitcoin ethereum um maybe you can find salana and you know the volume if you look at it is only you about 3% of the spot volume which is completely opposite than in the trafi market and we don't really like see a reason for this right there's like uh it shouldn't really be like this it should be technically bigger or comparable to the spot market right so we currently can only take out a tiny sliver of the total market only a few coins etc so the question is why why is that happening so we believe there are two big reasons for this so one is the technical challenge of bringing options to a decentralized financial ecosystem like it's just it's a blockchain. Uh skuomorphic approaches don't really work. You know, you can't build these option chains as easily. Liquidity fragmentation and in fact expanding on that just generally liquidity like we we you know fragmented or not we just need liquidity to get started to actually buy and sell options.

So at Panoptic um we basically identified this problem right this is the key problem is liquidity and we have um come up with a solution right so what we're going to do is we're going to unlock the existing $4 billion sitting in this ecosystem and essentially you know if you think of like basically what unis swap did to equities we will do to options in the defi space. Okay. So, it's going to look and feel a little bit different, but it's going to work much better and natively with DeFi. We're also going to by doing this expand the ecosystem cuz we're going to get more actors in TVL on board. We're going to be permissionless modular um as well.

So, we'll see that. Okay. So, how do we get to this liquidity? Where is it? Well, where is all the liquidity on Ethereum mainet right now?

Most of it is certainly in unis swap, right? So, we're going to go to a centralized exchange on the on the network. Uh, unis swap here. Here we're just showing example USDC ETH has a ton of liquidity. They're representing these LP positions as um NFTs.

ERC 721s nonf fungeible position manager. Uh, the the NFPM um handles this as a side note. So, how does how how do we expand this ecosystem? So what I've plotted here is the unis swap pool at the bottom. So we're thinking about this kind of a stack.

We're built we're composibly building on top of the existing pillars, right? So you see unis swap lps come in and they can provide liquidity to unis swap just normal univv3 lps. Okay, that creates deeper pools and better pricing for us. We'll get into how later. But you also have a whole new section of folks who want to just trade options.

they would not be UNIV B3 LPS but they want to trade options. So they're at the top there and then basically you can have existing UNIV3 LPS that just want better riskreward profiles. We'll see how by actually redeploying through us. So they'll take UNIV3 LPS will take their liquidity move to us and we'll kind of redeploy into Uniswap. So in this way we're symbiotic.

UniS swap grows we grow. We grow they grow. It's it's all kind of building together. That's how we get that liquidity. But how does panoptic work?

So panoptic works by again we got this uh unis swap v3 pool. Anyone can create permissionlessly a panoptic pool on any token you want that's supported in unis swap. So even longtail assets. Go ahead and create the pool. We are going to represent positions option positions as an ERC 1155.

So it's like a semi-fundgeable position manager and it basically is much more gas efficient than you know representing everything as like ERC 721 NFTts. We're going to just on a technical note represent like basically the token ID in the ERC 1155 will be an encoded version of what the option is that you're buying or selling. Okay. Okay. So we can actually encode that represent that as a token ID and then the amount or like the balance of that token ID will be how much you bought.

Again the liquidity providers will enter the ponoptic pool. This can again happen through basically these kind of two main ways. So one is directly or you know just LPS that want to do options or we can have existing unity 3 LPS re-enter through us. So how do you sell an option? The way that it happens on the back end is that you move liquidity from the panoptic pool to the UNV3 pool.

Just the act of doing this actually means you're selling an option. Buying an option is equally easy. You just take the liquidity that the seller put there and you move it from the from the UNV3 pool back to the panoptic pool. That is buying an option. We'll see an example now.

But there's also going to be a premium. So normally, you know, you might build in the premium by using an oracle and you can kind of check the price of the market and you know, then kind of do like a streaming kind of thing. We are going to not be using an oracle or Oracle s we're going to use a novel streaming pricing model we came up with which basically prices the option based on the trading activity in unis swap or in this decentralized exchange itself. So the trading that happens shown to the right will actually convert into an option price. So depending on what that activity looks like, you'll kind of see in this plot to the left that there's a gray bar kind of in the middle of the plot that represents the strike.

Time is on the x-axis. And if the price hovers around your strike, like the option you've created, the price will be high. If it takes off and does not really touch that strike zone again, it'll be a low cost, but it'll be the premium of the option at the end of the day. We're also going to ensure um at all times the health of our protocol. So, we're going to implement state-of-the-art uh decentralized liquidation networks to make sure that the you know the health uh of the all buyers and sellers uh is there.

So we can uh you can create options you know on leverage uh you deposit some collateral that will be drawn down if the position moves against you but you'll then get liquidated and if not um great you'll profit. All right so you can actually get more details at docs.panoptic.xyz. You'll also see this diagram in full but let's actually do an example now.

So, we're going to buy a long put by just moving liquidity between prenoptic and unis swap and we'll see how it works. So, a long put has this payoff profile. There's a strike price. The payoff curve is flat after that and it kind of goes up before that in a linear fashion. Okay.

So, how's it done? Um to the right I've shown you a seller with some deployed liquidity now kind of plotted on top of the unis swap pool. This is liquidity deployed from the ponoptic pool. this blue region there. We're ignoring the existing unis swap liquidity.

Okay, so that's the sellers liquidity. The buyer now comes along and says, I actually want to buy this long put. Let's say the price of ETH is 2500 uh USDC. So, what's going to happen is the buyer will take a chunk of liquidity. That's this little blue tiny little blue box to the left.

They took that out. They carved that out from the seller's liquidity and moved it over to Panoptic. So they in in other words they borrowed the LP tokens from the seller and what they're going to do is they're going to burn that and convert it to USDC. So now they're holding USDC 2500 USDC. All right.

And that's the current price. All right. So how do we do this? First let's just get a little bit of intuition about what happens to the payoff for the buyer as the price changes. Okay.

So I've plotted the payoff curve in the middle from before. I've marked two points on that. So one is price one and the other is price two. We can start with I guess price two right now because that's on the right. So price two it's some price whatever it is could be 2500.

Um and the payoff curve from the buyer will be on this flat curve. Why is it flat? because the position in unis swap from the seller's perspective is 100% USDC. Okay? Because the price is above this chunk, this carved out chunk.

That's just how unis swap works. That has nothing to do with ponoptic. That's just you. If you deploy a range in unis swap, it's either 100% one token or 100% the other token on either side of this range. Okay?

So it's right now it's 100% USDC. So the buyer holds 2500 USDC. the buyer or the the buyer owes the seller 2500 USDC's. The profit is zero. There's no profit right now.

They they can just deliver that back. They can, you know, just create the LP tokens again, give it back to the seller, and everything's good. So, that is true for any price above this strike price. It doesn't matter how high the price of e ETH is, doesn't matter because the seller's position is 100% USDC. Cool.

So, that's what creates the flat part. How do we get to the linear part that increases with decreasing price and ETH as the price now goes below the strike? Again, I marked two points, price two and price one. If we start from price two, what happens is um the price is now so low, it's very low, but importantly it has crossed the strike price and thus the seller's position is 100% ETH now. Okay.

And this is showing on the on the left graph there. It's 100% ETH. It should say that on the right graph too, but they're both 100% ETH. The point is The point is that the buyer now owes the seller one ETH. So it kind of flipped.

Before they owed them the USDC because the price is below the strike now, they owe them ETH. So as the price keeps going lower, the buyer still holding the 2500 USDC. Okay, nothing changed with that. But the cost of ETH just keeps dipping. But also, they now suddenly owe the seller in ETH, not in USDC.

So the buyer is super happy now because the price has gone below the strike. They're holding on to 2500 USDC. Let's say the price is 1,000 USDC for 1 ETH. Okay. How can the buyer close their position?

How can they exercise their option now? Well, they can just go to this market where it cost a,000. That's the pool itself. They just swap one ETH. Okay, that's going to cost them a,000 USDC.

That's the price. Well, okay, but they had 2500 USDC. So, they just are left over with 1,500 USDC and that's it. They just deliver to the seller one ETH. Okay?

And they just keep 1,500 USDC in profit. Buyer made a profit, sellers made whole, everybody's happy. All right? That's how it works. We can extend this and, you know, we we can go way beyond just buying a put.

We can do whatever we want just by realizing that these small liquidity chunks, you know, we can just like deposit an arbitrary amount of those. In Ponoptic, we support up to four Lex basically in this position. So, we can do things like Jade Lizard, Super Bowls, whatever you want. We're expanding now to the entire market to the any token you want and we're also expanding the, you know, number of options that you can use. So, to the right there, we actually kind of codified these options into like emojis.

So the first is a put, the second is a call, right? That's a telephone and so on. Um, so we actually are publishing more details about these things on our Twitter account. So this is our Twitter in the middle. We publish under the hashtag research bites.

So we give some information about like how to actually deploy these positions so on and later on when we launch we'll we'll you know actually do it on panoptic when you can. You can also check out our blog at blog panoptic xyz. This is our road map and I just want to highlight a few things. One is that we just successfully com completed our APDK review. We are starting our open Zeppelin review.

That's our going to be our second audit. So we're going to start that audit in in a few weeks and then we're going to launch on test net in a few months. uh it'll probably be May and then mainet uh you know later this year early fall and that will bring you know options to the entire DeFi industry. Okay, so I actually wanted to show you a demo of the product. Um so let's just start from scratch here.

All right, great. So here I am. Actually this is going to be the first live demo of Ponoptic ever. Here I am in our current like very early version of Ponoptic. Okay, I show up on the website.

A lot will change from this point till we actually launch, but anyway, I'm show up on the website. I'm kind of locked out right now. It says connect your wallet to view your positions. I'm going to do that. And here I am.

I'm connected. In the top left, I can see an overview of all of my current positions just in terms of my buying power, my collateral, etc. I can see my combined P&L graph to the top right. And I then I can actually go and scan my individual positions and I can even uh when we get there click on them and get more details on each position and I can make changes to them. You know typically you want to be more active in your option positions and kind of roll these positions.

So I can do that. Let's try to create a new position in panoptic. So here um I can basically pick my numerator. So in this case I pick die. I can pick my asset ETH.

I can choose the number of contracts that I want here one. I can pick a time scale which is just related to the the width of the deployed liquidity in unis swap. So you can kind of like change that. And then I have a feed tier as well. Once I pick these, this is going to toggle to checked up here.

These were already pre-filled for me, but I'm going to say continue. Great. I'm now in the die ETH pool. Okay. In the 30-bit pool.

Now, I'm going to pick a strategy. So, I'm going to pick from some templates here. And we have a few templates that'll show you some bullish strategies. I can pick some neutral and some bearish. Um, right now I'm super bullish.

So, I'm going to pick a long call. So, um, maybe I should do a bearish. That's kind of opposite. Anyway, so then now I'm going to do this. This is a long put.

This was the one we actually just talked about. So, I pick this and I can add Lexi here. This is kind of just a template I can start from. I can add legs. I can modify my existing legs.

So you see to the right it kind of lights up and it also lights up on the left. It lights up and also on the right. So I can kind of see which leg I'm talking about. I can add another leg. So there you go.

Another leg pops up and I can keep doing that. I can also delete them again. And importantly what we had to do for Panoptic here is we really wanted to for this graph to be very customizable this payoff curve. So you can come in and you can create whatever payoff curve you want. So what we had to do was create a very um I would say like a very advanced um like bare metal JavaScript library to actually be able to do that.

So I'm going to show you that now. So if you go here to the right, you can actually interact with this graph and it's like extremely expansive and interactive. So I can I can say no, I actually want my payoff curve to be more like this. I want to add a leg now and I want it to look like this. So I can do whatever I want and whatever it ends up being that's what I get.

That's the payoff curve I get. So I can stick with the template or I can just do my own thing. Um over time you can imagine even um you know we talked about this this a little bit before these gamma transforms. So you can um you can create arbitrary uh potentially arbitrary Greeks as well. We're working on that.

Anyway, point is I've created my position now. I'm happy with this. I'm now going to click submit and I'm going to be presented with a receipt for this position and I can kind of see the details of what I've just created and then I can go ahead and click mint. Um, right now it's not hooked up. I'm running this in local host but you'll be able to and that's it.

So that's how that's how it'll work. All right. So the team building this um we have Guom the CEO. Um I'm there as well helping with operations and uh then the rest of the team we have Brandon, Dr. C, Henry, and Susan who are doing a fantastic job making this a reality.

And yeah, I um I just want to yeah, thank you. To the left here, you can see some links to where to go seek more information. So there's a link to our website, we have our Twitter, we have our subdomains there, our Discord. Please join, ask your questions. And um yeah, I really um correct me if I'm wrong, but I really feel like I've changed um you know, your opinion about how derivatives will be done in DeFi by tapping into this existing liquidity.

But um yeah, seek me out. I I'll be at the conference. We're super happy to get connected and talk with you. Um but yeah, thank you for your time. Maybe we'll take some questions.

All right, there I think there are a few questions. We're also hosting an event. You can see that on the screen, by the way, March 2nd. That was really cool. Two quick questions.

Is the seller in your example um being compensated for the missed LP fees or something like this? Uh, and also how is the let let's just say in your example, how is the seller found or how is the seller paired, right? You're you're you're you're having someone pull out from sort of a seller's LP position. So where where is that LP position coming from and and also are their fees made up for in addition to the premium? Yes.

So there are two questions. So one is where like where does the kind of I guess the seller liquidity come from and you know where does the buyer basically go and find that liquidity in the first place and then also you know how is the seller compensated for the missed LP fees that they would have earned if they just deployed directly in unis swap. Okay. So the liquidity comes from so ponoptic LPS will deploy liquidity into the panoptic pool. The seller will have to deploy a little bit of liquidity themselves to create this collateral but they can do it on leverage.

So they can use a little bit of their own cap capital a little bit of the existing capital in the pool and then they can deploy this position uh they can sell their option and basically that gets deployed in unis swap. So that's where the liquidity from the buyer's perspective come from these sold options. So we have to sell it before we can buy. Um and yes, the way that the B seller gets compensated for the LP fees is actually through this streaming pricing model. So everything they would have earned in unis swap like they'll still earn here and they'll actually get a little bit more uh they'll get compensated a little bit more on top of that actually.

So we actually believe that um just kind of based on the market demand. So the point is they'll actually get more reward than they would have in pure unis swap. So that's why we're saying we believe we'll be able to bring a better riskreward profile to the participants of panoptic but also just because we're expanding the markets like you know put calls anything you're not just stuck with one particular position you can ever create which is what unis swap does right so that's what we're hoping so anyway I hope that okay cool y have another so usually pricing options is an absolute nightmare both computationally as well as um as well as uh consistently whenever you have quality data. So how are you structuring options pricing and making sure that one it's reliable and then two that you have the data integrity you need in order to um uh consistently um basically create a market. Yeah.

So the question is um well a statement first was that pricing options is like a nightmare normally right you have your black schos and math uh to do it um and then you know but for panoptic like how do we basically do that how do we you know price the option essentially and make sure it's you know it's like high quality data etc. So again the the data to price the model does not come from an oracle or any like essentially any data source per se. It just comes from the natural uh trading activity that actually happens in the underlying decentralized exchange. So just the swapping activity itself creates these price curves that you see on the left. We've drawn three different price curves that that is basically just showing you the individual swaps at least this like right because each swap changes the price a little bit.

So all of this is just kind of shown. So all those swaps are creating those price paths and those price paths in turn depending on how they touch the strike your so your range will make the option premium high or low. So we've kind of shown what we're seeing there on the on the far right in that sub in that subset graph is like fee can be 0% of black shores. It can also be more than black shores like four or 500% or like maybe on par with black shaws. So we don't need to worry about whether the like kind of the pricing gets computed correctly.

That's all we're all inheriting that from in this case unis swap automatically. So we not only do we get their liquidity for free so to speak, right? We also get the pricing of our options for free. So, it's all just natively built on top of this existing pillar. We're building another pillar and expanding it.

So, there's nothing skumorphic or um you know kind of discontinuous about this. We're just integrating into the existing ecosystem. So, we really believe this a powerful idea um to get this liquidity. All right, my time is up now with the great questions. Thank you.