Challenges of building on-chain option AMMs Part 1 | Daniele Ugolini, Rysk Finance | ETHTaipei 2023

our next speaker um Dan from risk Finance um he's a good friend of mine and also risk has been tackling in the option amn space since uh for like a year or two years now so today he's going to share some insights about challenges and opportunities in option amms woo all right thank can you hear me right yes thanks every everyone thanks Anon and the guys for inviting me so I'm Dan and I'm one of the co-founder of RIS Finance so what is risk Finance risk Finance is a defi options protocol and the main question that you might ask is like why do we need a defi options protocol so let's look into this this is a chart about crypto options uh basically is the volume in terms of number of contracts traded in the last year or so so this color over here like the blue whatever is dbit dbit you know we heard before on the present presentation it's like probably one of the main uh Ci or centralized Finance exchange when it comes to derivatives and especially for option so if you see the volumes here are pretty much 90% of the market in crypto options is De bit and one interesting aspect is I don't know how the audience is familiar with options but I can give a very brief overview why people or Traders should use options there are mostly few cases the main one is speculation you want to speculate of price going up or Price going down you can trade options and you basically speculating on this the other use case is edging so you want to protect in case of price is going up or price is going down and you can use options to Edge so if you see this chart you can see that the top and this is actually the highest volume since the beginning of the story of datab was November 2022 what happened November 2022 pretty much everyone knows I'm here and uh was FTX FTX crashed we are like one of this big dump on the downside and so lot of Traders user they decided to speculate because probably they wanted to make money on the price going down because volatility was high or the other side they wanted to Edge so the reason why we need options in the space um especially in Def is because options are very powerful instrument also on the especially on the edging side now if we look at this thereit has 90% of the market pretty much but who's behind that bit who's trading options on that bit like who's actually the actor that is making all those transaction on databit and here is a is a tweet from April 1st from Paradigm doco that's how the website is called paradigm. it's an ffq platform ffq means request for quote in a simple in a simple way I want to make a huge trade I'm a whale I'm an Institutional whatever I can say I want to sell 10,000 options um is there anyone on the other side able to you know buy those options and so that's pretty much just a very simple chart if we can call it that way and Paradigm doco on April so this is referring to the March volumes traded 38% of theid options so par. is for institutionalsales Edge found and so on so derit is probably doing 90% of the market out of this 90% almost 40% and that was April in March was even higher is just basically institutional market makers um Edge funds and so on so that tells you a lot about the status of crypto options and who's actually trading them now I want to see different models on you know I just mentioned RFQ and now I just wanted to go a bit deep on you know our different models so we have the order book I'm pretty sure most of you traded spot on some CH centralized exchange binance coinbase whatever and the way it's working is you know we have two actors in this case we have you know Naruto and cmon on the side and what they do they say Okay I want to sell I'm going to make this very very oversimplified but I'm going to buy 300 18 options for this price 0.0155 on the other side this guy saying I want to actually sell 127 for this price one Z whatever now the trade happens if one of the two actually say you know what this is not going to get filled let increase the price of any other actors is coming into it and say okay I'm going to buy for 0.0165 I'm going to match your 127 and we make the trade that's pretty simple order book right so if we see this this is actually a real one from dael so I got this last night from I don't remember which option but if you see we have pretty much 600 contracts that could be traded on this now what happened in this case is that it's kind of a peer-to-peer model like so we probably we have this seller Moon and this Naruto guy that may be sophisticated options users they may be Deion whatever they understand options they want to make this position and effectively if we oversimplify the model the just trading each other right so now let's look at this screen it's small on purpose because I want you to see all the chaos that is happening on this on this page so this is an order book for options the thing about option is that we have multiple xer on top so you see from 24 April to March 20 24 so like a year so we have 10 different exper for each exper we have calls and we have puts and for each one we have 20 plus strikes so what that means try to imagine how many Naruto and S Moon we need every second to make sure that we can get filled all those orders here so we need a lot of them a lot of sophisticated users to make sure that an order book is working or we need a network made by Bots running all the time every single second making prices for every PA that we see like this one is different from this one and it's different from this one and you know everyone require his own liquidity otherwise there is no way that Traders get filled so here is the alternative right and it's the RFQ basically what I mentioned about Paradigm yes here is an example that's a real example so this guy traded April 28 2,00 call and he traded 10,000 of them so if this guy wanted to trade on the order book as we saw we have liquidity for like 600 contracts how can you trade 10,000 and even on 600 contracts he would have got you know slipage from the you know the highest to the lowest so what they do again they use this platform Paradigm and they just say I want to trade 10,000 contracts and there is another one on the other side able to do this trade they agree on the price so the flow is I want to sell this option is there anyone on the other side ready to buy which price you able to give me fine I like the price I do the trade and so that's this actually account as we saw for almost 40% of the datab volumes and pretty much a lot of the options volume right now so couple of actors doing this huge trades here is a different model and is the amm so what happens with the amm is what if we actually create a volt or a liquidity pool call it whatever you want but the concept is the same and if seller Moon wants to sell and Naruto wants to buy instead of trading each other they trade with a vault the vault is a set of smart contracts with some logic and you know anyone is using a different one and whatever but what they do the counterpart in this case is not the other person is an automated Market maker it's an automated Vault but again who's in this vault in this Vault we have new actors and that's the good thing about using something like an amm in a low lowly liquidity environment because enables new actors and those actors they're not gigabrain probably they're not sophisticated options Trader probably they know about options but they don't have to actually because what they do they deposit liquidity in a very passive way and the sophisticated Traders a year they you know they do their trades and the counterpart is liquidated by those users so why amm is very powerful in defi defi is a very very low liquidity environment compared to traditional Finance compared to CI and as I show you before expecting to have thousands and thousands of Traders every single second being there and trade it's extremely challenging expectation but having passive users with they own chain liquidity that they say okay I'm down to do some liquidity providing I will get an exchange some returns and I'm a passive user so I don't have to be there like you know managing all the options I don't even have to actually really go deep into options and so that's what we're trying to build a risk in some sense like we have one volt it's called dynamica gy volt and it's it's one on the middle and then we have the Traders sophisticated Traders other protocals whatever they trade options the counterpart is the Vault and the vault is made by liquidity deposited by um the passive users those passive users deposit usdc into the vault and they expect to get what we call uncorrelated returns now I will focus on uncorrelated returns right now because that's a bigger overview with you know real actors so again liquidity providers deposit usdc on the other side we have market makers we have Traders we have other protocols like onchain protocols and some of them actually are here today to speak so that's pretty exciting um we have arbitragers people that want to make can Arbitrage between different chain or different you know exchange and so on and they trade options with this Vault the problem with option is h options could be a very high risk instrument like they have some risk it's you know it's not one of these product that that is no risk at all actually options are extremely risky especially if you sell options for example and so let's say that we have a very simple use case where everyone is coming to buy a single product and the vault is extremely short on that product that's not good because the VA could make huge losses so what we have to do to make sure that liquidity providers keep depositing liquidity because they don't want you know lose it all is to actually Edge so the way we Edge at the vault is like by using other protocols so simple example if the Vault you know is is basically at that time short in a sense to the market what we have to do we have to make sure that we for example long in the market for the same size so this vault is not short anymore right and it's basically edging his position and so we can do it by using Unis swap we can uh use GMX rage trade uh we have Unis swap range order there it's like you know we have different Integrations because the goal is to make sure that this bolt is actually not exposed to Market movements when you deposit you don't want to make you just want to be passive overall you don't want to see Market going up or down because you're not passive anymore right and because we do this game of rebalancing Delta so Delta is you know the measure of the sensitivity basically on the market movements I'm try to keep it very simple but if you are at Delta zero effectively what you're doing is say you're not exposed to market movement and so what we do like every time the Delta is moving um it could be negative or positive mean that the volt is getting its own exposure we try to rebalance it so this generated returns for liquidity providers they're not correlated to the market they're not correlated to when I say Market I in crypto market so eat Bitcoin as we know they're very high correlated usually and so what we try to do is that you get returns that they not depend to those Market movements and so now let me go a bit deep into how defi options actually works so when we look at crypto options we have this site and this CI FTX is there on purpose because the first time I made this slide FTX was alive and I wanted to keep it there as as a reminder so we have CI databit FDX and many others then we have some of the5 protocols not all of them but I'm talking about options protocol so for example PA that is talking I guess after me or in one hour whatever we have other like rebon is one one of the first making structure products um there are more obviously and the way they work so I'm just going to focus structure products for now the way the cool work and that's actually how they started to work it's like they do very basic strategy systematic basic strategy so as an example every Friday they sell a thousand of contracts or 10,000 of contracts as we saw earlier and the way they do it they do with an nfq kind of system so they say I want to sell 10,000 of contracts who's the counterparty for that and in most of the cases the counterparty are market makers and those market makers as you can see in the middle there is alamida same reasons I wanted to remember myself that they were there and what they do the process is simple they say Okay I want to sell this 10,000 contracts who's going to buy one of those actors and what they do at the meantime they sell on CI so they sell on CI for a price and they buy on defi obviously for a lower price and that's how they make their money right but this is a very big issue that means that defi options Market is relying on liquidity in CI so FTX collapse right what happen if deit collapse well options don't trade anymore because Market maker going to be like oh yeah we don't have any CI counterparty to do the trade as as we saw right and this is like 90% of the market so what we're trying to position ourself as risk is we want to be a market maker so not different from those guys in some way and and we want to serve those structure products other protocols other defi projects to trade options with onchain Native liquidity so that's our goal like we would like to be the counterparty like we would like to provide options market for those sectors because our bet and we might be wrong but hopefully not is that as def I mature people going to need to trade more options and when I say people I mostly mention other protocols treasuries and all those act onchain actors so that's how we try to position with risk now there are a lot of challenges it's not an easy game um and we Face them pretty much every day so I just wanted to share a bit of you know my experience on on this the first challenge is liquidity it's a huge huge huge Challenge and the main reason is right now when it comes to institutional liquidity especially in the options Market is very low and I can give you a very simple example if you are an options Trader like you know one of those institutional actors as we know they're very sophisticated they still prefer CI for many reasons even though fds could collapse and they know that and they could lose money they prefer CI because user experience is way better they prefer CI because there is liquidity on the other side so when you want to build something like we do as an amm and you are a Trader what you expect you expect to have lot of liquidity on the Vault otherwise it's going to be hard to trade and so that's lack of institutional liquidity like those actors usually they're not liquidity providers because they are sophisticated type of of actors and they want to make sure that as a counterpart that is liquidity so attracting liquidity is definitely one of the main challenge but when it comes to liquidity providers so like you know retail users like People Like Us whales whatever right now in defi unfortunately there is this attitude where risk in defi is too high like I hear this pretty much every day people coming to me and say why should I deposit into defi like protocol could be exploited um the you know the rate or the returns I got it's like they're not competitive with versus US Treasury bonds and stuff like that and it's all legit like it makes absolutely sense and that's one of the biggest challenge right now because we need to attract liquidity onchain liquidity but there are also advantages of that because again as I mentioned for example the point of Defi and most of the time we forget about it it's it's not just returns returns is definitely a good point and we working on making returns better but the point of defi it's way higher than that we want to connect the world globally we want a a a financial system that is accessible we want anyone to play with it and there's even one more thing to keep in mind there are a lot of users that are native users that they have their liquidity on chain and they don't want to withdraw their liquidity they have the liquidity there so most of the wells so it's just a matter of make sure we can attract them and I'm going to focus later on some of the thing that we need to get better to make sure that people are comfortable in depositing third one is regulatory um we don't know where the f is right now in the regulatory word that's one of the biggest challenge like I don't think anyone has an answer where we going and this is obviously not good because um people are kind of scared it's regulation coming is not coming we don't know whatever so that's something that unfortunately is completely not under our control but it's something that we have to be aware and the last one again increase onchain native liquidity so srisk one thing that we love to do is like working with other protocols we work with them in a sense they trade with us in a sense that we use them to Edge because that's how you actually create a financial system that is unique it's autonomous and not dependent from C5 this one performance so what I show you before right we have those sophisticated traders that trade the vault is the counterparty but who's making the price so the price in made by smart contract with some logic formula mathematics whatever but the smart contracts making price it's very very challenging because options they have a very unique price Model like to keep it very simple when you price on options you pricing the probability of something to happen in the future and pricing the probability of something to happen in the future into a smart contract it's pretty challenging um so it's very important in terms of performance to make sure that we have traders that actually want to trade those options to have a good pricing model to have liquidity to have a small B bid and that spread because when I show you earlier on on derit for example this the bid and that spread isn't that bad I mean at least for for what I show you so that's one goal that we need to keep in mind reduce slipage slipage is also most of the time Al a function of liquidity so the higher liquidity into the BT the lower should be the slipage but it's not always the case and it's also a bit more complex than that but having low slipage means that as a Trader if you want to buy something you know which price you're going to get and so that's very very important especially if you trade options then obviously like front run Meb those are like great concept we trying to work on especially like how do you reduce front run right so when I mention for example the edging if you put all this edging on chain people know what time you're going to Edge or when you're going to Edge so it's very important to make sure that we can um reduce front running in that sense third one it's Capital efficiency so this is probably or at least this my personal view the most important one for attracting liquidity so here is the data about databit CI so let's say you want to sell an option if you go to derit you basically post one it collateral and you can sell 10 contracts like okay that's good if you go to something like rebound that is fully collateralized and that's a decision because they want it to sell covered Co so it's it's on by the sign with one it you sell one option so you sell one option you get a premium but if you sell it on thereit you get 10 times that premium effectively so obviously the capital efficiency matters a lot espe esally to guest sellers we we made partial collateralize we made improvements we still far away from some theay databit we're working on we try to have margining and everything to be more efficient but this matters a lot because it gives you an idea of the status of the market before when I mentioned how defi is working right now we mostly have def protocol selling to market makers and so they buy from def5 and they sell on Dat bit why not the the other way around mostly because of capital efficiency because it will be very high expensive for them or like Capital inefficient for them to do the other way around so most of defi when it comes to options right now it's about selling it's not about buying this one risk management um this is probably one of the biggest challenge for a protocol like ours so to make sure the liquidity providers deposit money deposit usdc and to make sure that we actually manage and when I say we I mean you know what I wrot it over there like codify Risk Management um it's very important that we write code that is able to manage um the risk that is able to hedge properly to reduce obviously losses in case uh there might be some or you know to make sure that the pool is not is not exposed to Market movements so that's extremely challenging because it's very hard to codify those you know risk management rules in a very Advanced way and again options are product that might be very high risk losses might happen so it's extremely important to Edge the other big point is we are all defi so risk protocols is trading and with other protocols when it comes to Edge so as a show we use Unis swop GMX and so on um and as we saw before on the presentation for example on on the funding rate funding rate it's for example hard to predict like you don't know how much you're going to pay for funding rat so if you want to use a Perpetual to shirt because you are hedging in the sense um you actually don't know how much you're going to pay for when you're taking the position like every day you say okay we pay a lot of money for shirting but it's hard to predict so most of the protocols are there it's they are more expensive compared to to C5 when it comes to edging and so this is reducing obviously the returns for liquidity providers and they're not mature yet like defi is still early on and something that I always say it's like we still haven't found a proper stable coin so it takes time to go there and so I think that's pretty normal the other thing about risk management that I stress a lot it's like how can we keep the five trustless for trustless I mean sometimes you can see this C defi hybrid where you know they use some traditional Finance infrastructure or traditional Finance legal agreements whatever and basic you're getting the worst of the true world and doesn't make sense so if we want to keep thei we need to keep it like trustless this is a big one security every day I speak to people and if you're trying to Art new people into defi most of the time they're going to be like that place is not secure that I exploit every day the thousands of millions lost yet it's just a list and again I keep it very small so you guys can't read it on purpose because I wanted to show you how many we have it's just like the beginning and it's not just defi to be fair there are also some C the CI component there there is databit I guess somewhere here I don't remember where but like there is databit there is some Market maker so that's something that we need to face challenge every day and one of the reason we are also on these events obviously try to great to mature the space together in a sense where you know we need better tooling we need we have Auditors Auditors enough Auditors is great but it's not enough we need keep monitoring we need a lot of better infrastructure on security otherwise no matter which prodal You're Building will be hard to get liquidity especially on the institutional side they still prefer and this is like pretty interesting they still prefer to put money on something like FTX than than defi because they still feel more safe safe and that's something that it was definitely a great lesson there third Point user experience so this is something that I face myself trying to trade options on risk on other protocols doesn't matter it's the same thing so you basically need to gas you need to bridge you need to go because again if you want to keep a protocol like ours it will be very hard to be on Main net um computational Power and so on so we have to be on layer Che and that means bringing it means all the things that you're saying here like you want to make a transaction you need to approve it first and then you need to trade again this is not just for options amm it's in general but if you trade on dabit and if you trade on options amm you're going to feel the difference and most of the time it's not because of the fault of the protocol but like the environment we are so again that's extremely important to figure it out that if we want to be competitive and keep in mind what I said at the beginning option space is pretty sophisticated right now most of people are extremely Advanced users Traders sophisticated and they don't want to do this every day or like every 10 seconds or whatever so we need definitely to make this world better last thing is transparency so every time and there was like myself I think I was one of the first one I was always like oh yeah no risk is great because it's transparent versus something like that bit or you know FTX or whatever yeah it's a narrative but that to me is like the the best example like yeah it's transparent but who's actually read the transparency like how many people here are going to read smart contracts especially complex one like could be ours uh because you know all the pricing mechanism all everything that we have inside no one so yeah it is transparent but that doesn't mean that it's secure or it means that it's it works perfectly and we had lot of example in the last few years years of protocol yeah they were transparent but they blew up anyway right so it is very important to have education on that it's very important to be very clear as a protocol as a team building it like about the limitations about the risk about everything that's going on because again that's extremely important last Point that's probably one of my personal battles since the beginning apy is the worst thing I think we came out with defi like we see them few years ago like everything was like 1,000 x apy 500 x apy whatever percentage and it's completely misleading it's completely broken it doesn't actually tell you like the risk of what you're getting it doesn't actually the number itself it could be based on some weird calculation that no one knows about it and so again when I try to speak with people and try to say okay you know we building this and so on and people ask cared about because it's like oh yeah I deposited years ago in this protocol 500% apy and then I got wrecked I was like yeah that's that's that's it is so as people working in this space we need to get better we need to get better on measuring standardized an apy what is the risk behind it and and so on this is my last Point um so again we are building an options amm we saw some of the challenges and the main reason why we're building an options amm is to mature the D5 space the reason why we're doing again it's mostly a matter of liquidity right so we are in a low liquidity environment and the amm is the best solution that we have right now to make sure that you can actually trade with a non-chain counterparty and we love to trade with other protocols we building this not for market makers we