"Exploring DeFi Options" - Alexis Gauba & Zubin Koticha

Alis and Zubin from open and their talk is about defi options so we're going to explore that topic and Alexa subba I'll let you take it from here hey hey how's it going awesome hey y' just share screen okay cool um yeah so today super excited to be talking about defi options um so we'll talk a little bit about what options are and then how they fit into this whole defi landscape um okay so the premise of this talk is we're going to chat a little bit about how one of def's killer apps will be derivatives and then hop into options in particular um and not only are options going to be a big unlock for defi but defi is also going to be a big unlock for options themselves you know options are these traditional Financial Primitives that have been around for so long but defi has the potential to elevate them to the next level um so what are options they're a derivative instrument and we'll chat a little bit more about what a derivative instrument is in a second um but they can be used as tools for financial protection and insurance um also for speculation and because they have this kind of wide variety of use cases they create this massive Market where we're seeing over $300 trillion do of yearly volume for these options um and they're an extremely versatile instrument which we'll get into in just a second yeah and so some of the incredible things that can be done with options are you know they're just so versatile and have so many use cases one example is you can actually take any portfolio and by using a set of options on those uh portfolios you can create the risk-free rate you can completely and utterly remove all the risk from a portfolio um and you can also completely remove the risk from an option itself through something called Delta hedging so there's like some really incredible things you can do in order to hedge risk using options um but also options allow for the creation and expansion of an entirely new asset class which is called volatility itself right uh we in the crypto World know that sometimes cryptos go up sometimes cryptos go down uh but there's no way to kind of hedge yourself from this volatility from this bumpy ride uh unless you have options where you can actually trade volatility itself um without taking a directional bet on if eth is going to go up and down and there's actually a a theorem that proves that you can you know using options on any asset in the world you can create any payoff structure so any futurist contract any other derivative you know you can use options in a very interesting way to create any other payoff structure and that makes them the ultimate synthetic asset so what is a derivative I've just been talking about what can options do but what are they well a derivative asset unlike an asset itself is something whose value is based entirely on another asset right and so the asset that it's based on is called the underlying asset and the assets the the derivatives that people here probably are most familiar with might be Futures and options and what Futures and options are are they're based on a future trade that hasn't even happened yet where you trade the underlying asset like eth for cash right and a Futures Contract is pretty simple you have an obligation to make that trade in the future um and both sides SES are obligated to make a trade one of them is paying eth another one is buying the eth with dollars or usdc and since both people are obligated into this trade in the future for one of the sides the trade is going to be profitable the other side is going to be unprofitable and so neither of them can back out of it so one of the sides could make a loss when this trade happens in the future when the future expires essentially um and so because it's a fair trade since both people are obligated there's typically no initial cash flow no one's getting kind of the better upper hand in this deal both of them could make a loss in the future but in an options contract kind of like the name suggests one side has an obligation the other side has the option and so the one who's selling the option right they essentially have to make the trade in the future the person who bought the option as the name of the option suggests can choose if they want to make the trade in the future and because they have the right to choose if they want to make that trade in the future eth for usdc they could actually be flat or positive on XPR they're never going to enter in to that trade if it's you know costly for them if it causes them to have a loss so options just like real life are always helpful to have it's always helpful to have as many options as possible in real life and that's why options in finance also cost money why they're valuable you always want to have as many options as possible um and because options are positive in value the person who's selling them gets premium for selling them they get this initial cash flow they're paid money um and the reason one way to think about it is they're entering into an obligation the seller is obligated and they might make a loss in the future so in order to put them into the situation of obligation the buyer needs to pay them money they need to pay them that premium so now we can chat about a couple of the different kinds of options that exist and so there are two main options put options and call options put options give you the option to sell an underlying asset so for example eth for a specific price which we call the strike price and this is helpful when you think that the asset is going to go down in price um so for example say that we have eth at $200 um and there's like a black Thursday type of event where eth Falls to $90 if you're the holder of this option you can still sell your e for $200 so this put is giving you this this protection this hedging against eth price falling now we also have call options and call options are the option to buy the asset so for example eth um for a specific price which again is the strike price and this is helpful when you think the asset is going to go up so say uh I have a call option for eth at $300 um and then e skyrockets to ,000 well I can still buy eth for cheap for $300 using my call option um and so that's kind of the power of a call option so one common misconception is that the opposite of buying a cook put put is buying a call but that is not the case the opposite of buying a put is selling a put um so there are kind of four different types of transactions that can happen here you can buy a put you can sell a put and you can buy a call or you can sell a call and each of these four are completely distinct with their own separate payoffs um and then when you're buying an option kind of like Zubin mentioned earlier you have to pay a premium to get this optionality um in this case you have the right to buy or sell eth if it hits the strike price but not the obligation and so you have to pay the premium for that optionality however when you're selling the option you are taking on an obligation if the option buyer does exercise you are obligated to pay them out and so you get paid a premium for taking on that obligation and we can look at a specific example with a put option um so say we have e uh and uh this is a put option on eth we've got a strike price of 200 usdc and it's expiring on December 31st so here this option gives me the option holder the right to sell eth for 200 usdc anytime before December 31st but that again that's a right it's not an obligation so if e skyrockets to a th000 um I don't have to sell my e for $200 I just have that ability in case we end up in a black Thursday like scenario where we've got eat at $90 or eat below $200 at any point so this $200 is effectively a price floor for me uh $200 is the lowest amount that I can sell my e at um and so it's kind of creating this asymmetric upside payoff which we can see here um so as eth price goes up I continue to earn more on my eth um but I am capped at $200 with $200 being the lowest price I would sell my eth at and so that's kind of what buying a put option looks like now on the other side we have selling a put option um and you might be thinking okay buying a put option seems like a pretty good deal it can give me this hedging and this this kind of risk management type of property now why would I want to sell a put option when you're selling a put option you're earning this premium um and many people kind of want to earn this premium um for different reasons and different folks take different views on it um and so for some people they think about it like they think that eth is going to go up in price um and the option buyer is only going to exercise this put option if eth goes below $200 so they believe that eth is going to continue to rise in price and so if the option buyer doesn't exercise on them then they just take their premium and leave so that's one view that some folks will take for selling options another view that people will take um is that they'll think about this as monetizing a limit order so a limit order would be if I were to go to an exchange and I were to place an order to buy eth at $200 here if I'm selling an option I'm earning a premium um and if a us and if a user option buyer comes in exercises um then I basically have to pay them out 200 usdc so it's like I'm buying e at $200 um and that's another view that some folks selling options sometimes take so how are these options actually traded in traditional financial markets well they're traded very similarly to the way that you could trade other assets as well for example centralized exchanges um so when you go and try to buy stocks you would go to the New York Stock Exchange uh for options two of the major exchanges in the United States are the Chicago mertile Exchange and the board the Chicago Board options exchange and these work exactly like you would expect them to they're run by a centralized operator and people come and buy and sell and place limited market orders as you would expect um but then there's another way which is even more popular to trade options and this is OTC overthe counter trading and so people make literal legal deals like literal legal contracts uh for large orders off the exchange it never touches the exchange in the first place and so a lot of people often talk about how defi is going to affect centralized exchanges with things like Unis Swap and amms affecting uh CFI in a real way as as a deck's kind of uh Renaissance is happening and a growth of of of dexas but how does defi affect OTC trading so well one way to think about this is to First understand why people do OTC trades why would you not just go to exchange to make your trade when an change exists why would you go find another counterparty and do it with them well the reason is you know there are many reasons but one of the reasons is slippage right so you can imagine that there are for any asset let's take Tesla there's hundreds of different uh kind of potential expires there's hundreds of different potential strike prices for an option so there's thousands of different options trading on just Tesla uh and each of these options is a completely different contract and so if I went to a single one of these options contract and tried to make a trade on the order book there would be a lot of slippage as in there would be a big deviation on the price just from my one single trade if I was a large Trader or a whale so if I called up a counterparty and I told them that I wanted to make this trade I could usually find a better price we could kind of negotiate a more fair price than I would be able to get on an exchange the other thing is customization right one of the reasons people like to do derivative trades um you have to remember they're legal contracts and so you can go into the terms and change them uh and there's a whole class of options called exotic options which are really Advanced which change different things about options there's barrier options and there's VA budget options and there's look back options Israeli options there there's all these number of different types of options that are trading and if I wanted to kind of get a bespoke contract I would talk to you know a counterparty and we would come up with a legal framework and and do that trade the other thing is collateralization exchanges have very strict collateral requirements maybe I have a trusted counterparty a friend and we could say let's do this with lower collateral because we trust each other that would unlock Capital efficiency there's also custody maybe we don't trust the exchange to custody our funds well an example of this is you know in CI you would have to trust derit um and maybe I don't trust uh derit and I trust this other counterparty so I want to do a trade with them OTC and then the last thing is regulatory Arbitrage right the derate example I I mentioned Americans cannot use derate and so maybe uh they are still kind of uh you know sophisticated Market participants they could call up someone else and do the trade OTC and that may be the only way that they could get the trade done now these are a lot of different reasons but the main things to think about is that you're you know people don't necessarily trust the exchange they trust each other and they want to create all these custom contracts now ethereum is this incredible thing where you can create custom Financial contracts and where you can don't have to trust your counterparty you don't have to trust an exchange in order to have a fully collateralized position and settlement can happen through like a blockchain itself and so you can imagine ethereum being this incredible thing to replace 40 50 60 pages of legal paperwork that are required whenever an options trade is happening and this is a massive unlock for the options markets it'll also allow smaller players to enter people who are maybe not not kind of attached to the large OTC markets or the large extra exchange traded option markets and it allows this entire geography of individuals to to access option markets which is also really exciting unlock and then kind of the classic things of trustless the massive legal overhead of having lawyers draft up these documents and pseudonymity are things that people really love and will make ethereum incredible for the options world so you know this was kind of an A A A upload on how options work why they're so exciting and why defi options are such a large opportunity um but one thing that we would kind of love is is to be a source of Education uh for options because they're such an exciting market so some different ways you can learn about options the first is KH Academy has a great overview on how options work uh also you can get started at open. Co we are a defi options protocol um that has options trading on ethereum and number of different erc20 is um and as well as going to convexity open. that's a white paper for open which describes options as well as defi options spec in like more detail uh if you're interested in kind of chatting with us and and and talking about the you know ability to build on open or even uh kind of get help from us in building your applications uh you can join our Discord we're always happy to chat and talk about options and talk about uh defi derivatives um that's it for for me um we definitely have time for questions if uh people interested great yeah thank you Alexis thank you Zubin we do have a couple questions as well so let's just jum jump in um the first question is for you Zubin um what is that on your head that I see on the live stream right now oh this is a zoom hat you they have filters and I I like this hat because it's like hat setion I have a hat on my hat which I like okay yeah we had yeah we had a lot of eager people uh wanting to know the answer to that so now that we have that out of the way we can move on to the less important questions yes this this was important yes this was very important um so what have been like what are the the biggest challenges you see uh in kind of getting crypto options um you know have been either you know in the past so far or in the future kind of making this a viable product for people to use this is a a really great question and Alexis also has a lot of thoughts on this as well but from my perspective one big thing is capital efficiency uh in traditional Finance there's a lot of crazy trust relationships and people know each other and you know there's there's a strong legal framework in in kind of place there um and so sometimes you only have to put you know a dollar down for an options contract with a strike of $100 and so you can imagine that this is there's a lot of Leverage you're you're you can be 100x leveraged or even more right um and in defi where people don't trust each other they don't know each other it's much more difficult um and so that's been a big challenge but for open V2 we're working on some pretty crazy Solutions uh that make options much more Capital efficient uh in in defi Alexis do you do you have a kind of also yeah no definitely Capital efficiency is a huge one I think another big thing is education like Zubin was talking about for the first time these products are going to be available to anyone anywhere um and so a big part of that is also teaching people about what are the best ways to use these things and making sure that they're interacting with them in a safe Manner and that they really understand what's going on that's interesting I'd love to kind of dig into that for a second because I mean I think that's kind of a challenge that a lot of defi products might face uh these are are traditionally having products for you know sophisticated investors market makers Etc and now there's the idea that like anyone with a a cell phone can can use them I mean should we expect you know the average person to actually want to use these sophisticated products or they going to be like bundled into you know a very kind of simple platform simple product for the average person with complex stuff happening uh behind the scenes No I think that's a really great question and definitely something that a lot of D5 projects are probably tackling right now I think you know one of the most powerful Parts is that we have all of these protocol layers like we have this options protocol that anyone can build anything on top of so you can have a sophisticated interface for people that are really familiar with finance and want that kind of experience and then you can also have interfaces that are specifically tailored to folks that want to kind of gain the power of these instruments but not necessarily you know wanting to be confused with all of the intricacies that are happening in the background and there are some really powerful properties that this unlocks in terms of hedging and protection that just weren't available in di5 before and so those kinds of things would be really helpful for lots of people to be able to access in a way that is understandable in a way that they do know what's going on um in a way that is easy to access and so I think with the protocol being available to everyone at the Smart contract there we can really build applications for different audiences on top which is exciting yeah and and to add to that I think like it it's very important that defi Builders Express that defi is still very kind of early there's a lot of protocol level risk there's consensus level risk there's risks that exist in terms of uh regulatory so I I would say that as a user um it's very important to educate yourself and understand that there are risks in in everything you use in defi um this still is the wild west I think as as many folks in defi like to say and it's important that if you use these protocols you kind of uh to a certain extent try to try to understand what's going on under the hood and I think that's also as Alexis mentioned a big challenge is is is education great um and then so one more question we've got and this was directly from chat um it might require some disambiguation from you um but uh so how do these options get efficiently priced uh if they're all decentralized this is a great question so there's many different ways uh but the thing is for us our options are erc20 is and as such they can be put onto Unis Swap and then people can trade on Unis Swap and Unis swap obviously has like the constant Factor uh function uh to to come up with the new price after a trade before a trade Etc so the way we do it right now is that we seed pools on Unis Swap and then the market kind of will determine the price from then on um we are working on a option specific amm that responds to the market as well uh and reprices them but our goal is like we don't think any centralized entity should ever price these things it should be the market and supply and demand forces that are pricing them and that's what Unis swap functions for right now great okay well thank you Alexis thank you Zubin really appreciate you having you both on with us today um great last talk to wrap up defi Summit um really appreciate it awesome thanks so much everyone thank you bye