- Establishing a Framework
In traditional financial markets—or, as we like to call it, “TradFi”—options are widely traded, structured, and embedded into all manner of financial products, from stocks and currencies to sovereign interest rates and corporate credit. Options are among the most liquid asset classes globally and are commonly used by commodity producers, hedge funds, and liquidity providers for both speculation and hedging.
In crypto, demand for options has steadily risen despite the overall downturn in spot and futures markets. This growth can be attributed to the increased presence of institutions and sophisticated traders across crypto and their accompanying demand for capital-efficient forms of leverage, convexity, and risk transformation mechanisms.
This demand-side growth has elicited reciprocal supply-side growth. In the past year, numerous quantitative trading firms and liquidity providers have kicked off initiatives to build out options trading desks in an attempt to capture edge from the volatility in the markets.
Despite these promising tailwinds, though, few products in the crypto options landscape have found product-market fit, and options trading volume in crypto is still small relative to the volumes traded in TradFi. Of this volume, a tiny fraction is captured by on-chain exchanges, with the majority of trading activity occurring on Deribit, a centralized exchange.
This discrepancy between off-chain and on-chain volume is not for a lack of effort: in the two years following the “DeFi summer” of 2020, VCs deployed significant capital into options-related projects in crypto, and many talented teams have built functional products that have nevertheless failed to achieve significant adoption.
In this three-part series, we'll first share a framework that outlines the core properties that make financial marketplaces successful, then evaluate the crypto options landscape as it exists today, and finally present a solution that we believe addresses the unique needs of participants of the market.
Establishing a Framework
To understand the challenges preventing the adoption of on-chain options trading venues, we must first understand the essential properties of a successful financial marketplace. Successful on-chain marketplaces require:
- Security and resilience: The marketplace must remain solvent and secure throughout adverse long-tail events.
- Financial viability: The instruments offered by the marketplace must serve a productive use-case by solving a real financial problem.
- Deep liquidity: The marketplace must offer sufficient liquidity and enable market participants to efficiently and quickly enter and exit positions.
- Accessibility: The marketplace must address the unique preferences and workflows of the market segment its targeting.
- Rationale for building on-chain: Building on-chain must offer some real advantage over building off-chain that's strong enough to make the performance and development tradeoffs worthwhile.
The appeal of the financial products offered on an exchange is irrelevant if the exchange is insolvent. Ensuring the viability of the financial products offered is a necessary, but not sufficient condition for attracting meaningful liquidity. This liquidity needs to be tapped into via an accessible user experience and well-architected APIs for programmatic integration. A decentralized marketplace that meets all of these criteria, but that doesn't address the unique design trade-offs that on-chain applications must confront will fail to attract adoption over centralized alternatives.
A market that embodies these 5 attributes maximizes the probability of its long-term success.
Security and Resilience
Prudent stewardship of user funds and guarantee of solvency is a fundamental prerequisite for building a successful marketplace, and, as recent events have shown, not something that can be taken for granted simply based on reputation or trust.
In TradFi, marketplace resilience is enforced through regulatory oversight and insured via backstop liquidity providers—such as central banks—who can step in during catastrophes. These systems are not fail-proof and are prone to systemic overextension, as illustrated by the 2008 financial crisis. In crypto, the risks of using a centralized exchange are even more pronounced, given the lack of backstop liquidity providers, the obscene amounts of leverage offered, and an evolving regulatory landscape that has not yet caught up to address the unique challenges in crypto.
In DeFi, the resilience of a marketplace is determined not only by the integrity of the smart contract code but also by the economic incentives encoded within the protocol. Terra is a famous example of a protocol that worked exactly as intended but had fundamental flaws in its economic design, in which demand was driven by 20% yields that were artificially subsidized by the protocol's treasury.
We will dive deeper into the inherent flaws in the way leverage in crypto is constructed, as well as idiosyncratic risks which affect crypto exchanges, in Part 2 of this series.
Financial viability refers to financial products that solve real, tangible problems—the financial equivalent of product-market fit.
Viable financial instruments enable productive risk transformation or package assets into more commoditized and liquid forms. CLOs and ETFs are illustrative examples of useful products in TradFi: CLOs enabled the largest bond investors—pension funds and insurance companies—to invest in riskier corporate loans via the risk-transformation mechanism of securitization, while ETFs enabled anyone to quickly and cheaply invest in specific categories of stocks.
In contrast, unviable financial products fail to solve tangible problems, or worse, consistently cause financial loss for users. In crypto, protocols sometimes use token emissions at net-negative economics to disguise the viability of their product. This works for a period of time, and there have existed countless crypto projects that have successfully bootstrapped a community of users using this method, only to later collapse after their yield incentives dry up.
The viability of crypto assets and their derivatives is determined by their economic function, and not by unsustainable external incentives such as excessive token emissions.
Liquidity refers to the ability to buy or sell an asset quickly and with minimal price slippage. Market liquidity has powerful network effects, though bootstrapping liquidity for a new market can be difficult, as it is a classic chicken-or-the-egg problem: buyers want to go where there are already sellers, while sellers want to go where there are already buyers.
A market's overall liquidity is a function of the number and size of its participants —DraftKings has more liquidity than your neighborhood bookie—and the liquidity profile of the assets that are traded.
These are some of the most important characteristics that influence the liquidity profile of an asset:
- Fungibility: how exchangeable one unit of an asset is for another unit. Fungibility is a spectrum, with perfectly fungible assets on one end and perfectly non-fungible assets on the other— fiat currency, whether in physical or digital form, is a perfectly fungible commodity. Generally, perfectly fungible assets have deeper liquidity than non-fungible assets. Fungibility was key to the success of perpetual futures—by consolidating liquidity that was previously fragmented across multiple dated futures, perps grew to become the most liquid asset in all of crypto.
- Pricing certainty: Some assets like BTC and ETH trade 24/7 on transparent exchanges with public price feeds. Others—like equity in early-stage startups or blue-chip NFTs — trade hands less often and are harder to value. All else equal, assets that are more frequently traded and that have canonically accepted pricing methodologies will be more liquid.
- Transfer costs and settlement speed: Assets that require physical delivery will be significantly less liquid than assets that can be digitally transferred. Buying and shipping 1000 barrels of crude oil is significantly more costly and difficult than buying 1 oil future on the CME.
- Narrative: Narrative cycles are fickle and unpredictable; however, during periods of intense interest in a particular sub-sector or meme, liquidity for a market can increase tremendously as more consumers look to participate and vendors look to monetize the increased interest. A few recent examples in crypto include the dog coin craze and layer 1 rotations during the peak of the bull market, which at various points made DOGE, SHIBA, SOL, AVAX, LUNA, and MATIC among the most liquid crypto assets.
- Capital efficiency: Assets that can be purchased on leverage have greater liquidity than assets that can't. For example, the daily volumes of levered perp markets in crypto exceed the daily volumes of spot markets by a multiple of 4-5x.
As an example, consider trading ETH/USD spot vs. trading power perps or variance swaps. For a vanilla spot transaction, both parties have reasonable confidence in the expected clearing price, as the current price of ETH/USD is posted on every exchange in real time. Additionally, both parties are fully aware of which outcomes are profitable, e.g. buy ETH, ETH price rises, profit.
These same parties would likely be less familiar with both the expected transaction price and the range of profitable outcomes when trading variance swaps or power perps. Lack of pricing clarity negatively impacts their liquidity profiles, as market makers charge higher transfer costs to make up for greater uncertainty. We would expect, then, for the daily volume and liquidity of ETH/USD spot to be much higher than that of these exotic derivatives.
The liquidity of any marketplace is impacted by the liquidity profile of the assets that are traded on it—in general, fungible assets that people know and understand have the deepest liquidity.
Accessibility is the ease of onboarding onto and using a marketplace.
If a user interface is difficult to use or the trading process is cumbersome, costly, or time-consuming, people will avoid that marketplace in favor of easier-to-use alternatives. A great user experience makes it both easy for new users to start using the platform and seamless for existing users to consistently return.
Accessibility encompasses many stages in the trading experience: how easy it is to move funds onto and out of the platform is one important part of the flow.
Robinhood is a classic example of an exceptional user experience. Robinhood waived broker commissions and introduced fractional stock purchases, which appealed to newer investors who previously had not participated in financial markets due to the high upfront cost of investing. In doing so, Robinhood helped usher in a younger generation of investors with its sleek, mobile-first design. As users got more comfortable, they experimented with more advanced features like options trading. Robinhood's ability to integrate these varying levels of complexity into a beautiful and consistent platform was key in driving its popularity.
A user's experience on a platform is a combination of feature engineering and interface design, and neither can be neglected for a successful marketplace.
A Rationale for Building On Chain
So far, we've seen many skeuomorphic attempts to bring web2 services and TradFi products onto the blockchain. In short, skeuomorphism means translating solutions from a previous technology to a newer technology without considering the unique features and tradeoffs provided by the new technology.
In their current form, blockchains have low throughput and high latency, which greatly restricts the design space for on-chain applications. A centralized exchange can process more than a million transactions per second, orders of magnitude greater than any existing DEX or blockchain can process today. These performance disadvantages require on-chain protocol creators to think critically about the new technological primitives that blockchains offer and whether applying those primitives can result in a superior product experience over their magnitude-faster centralized alternatives.
From our perspective, three key advantages of blockchains over traditional fintech are:
- Trustless and atomic settlement
- Cryptographic proof of asset ownership
- Global availability and composability
Trustless and atomic settlement
The exchange of financial assets has historically relied on strict trust between multiple actors. In traditional markets, we've exported this function of trust to a supply chain of counterparties encompassing DCMs, FCMs, CCPs, broker-dealers, custodians, prime brokers, and central banks. Every once in a while, an unsuspected event exposes the fragility of this supply chain, and the resulting failure wreaks havoc on the markets, like when nickel futures markets broke after a large trader refused to cover their $10B short position on the LME.
On-chain protocols obviate the need for trust between counterparties by enabling the programmatic and atomic transfer of assets via a decentralized compute network. This is orders of magnitude more efficient for transactions like settling trades or sending money to your relatives in another country.
It's important to note that while trustless settlement reduces the reliance on the integrity of your counterparty, it brings its own host of design challenges for ensuring the safety and security of user funds. A bug in the order book matching logic for a centralized exchange is a costly but reversible mistake. For an on-chain DEX this same mistake could result in complete ruin and tens of millions of dollars lost.
Trustless settlement can and will be weaponized against protocols, and must be combatted by a robust and disciplined security posture.
Cryptographic proof of asset ownership
Cryptographic proof of ownership is a core primitive that underlies all crypto assets. This primitive enables self-custody and trustless collateralization and has profound implications for the future architecture of financial applications
For example, on-chain marketplaces offer proof of reserves by default. This proof is broadcasted to the public in real time, instead of periodically to a select handful of private auditors. This transparency helps prevent nefarious behavior, such as exchanges mishandling user funds, while also producing positive second-order effects such as the democratization of access to financial data.
Transparency is a foundational principle that permeates all of crypto—including the open-source ethos shared by many protocol developers—and over the long run will lead to markets that are safer, more efficient, and more equitable than their opaque alternatives. It's impossible to imagine a world where the NYSE open sources their exchange code, but this practice is common and encouraged amongst premier crypto protocols.
Global availability and composability
Programmable blockchains enforce a new design paradigm in which publicly available interfaces (APIs) are provided for every application by default. This is huge. Even if a protocol isn't permissionless, it can conform to standardized interfaces, such as ERC20, or the SPL Token program, to offer extensible points of integration.
On-chain composability enables modular decomposition of concerns and risk across protocols. For example, tokenized positions across multiple lending protocols may be used to construct a securitization protocol. Leverage for an on-chain exchange can be composed via a separate prime brokerage protocol, which doesn't affect the fundamental integrity of the underlying assets. This is categorically different than traditional finance, in which access to interfaces are permissioned via regulatory licenses and industry relationships, and the integrity of interfaces is guaranteed by trust rather than formally-verified specifications. The design possibilities here are incredibly exciting, and we think that as core primitives—such as oracle infrastructure—become hardened, the pace of innovation in crypto will rapidly outpace developments in traditional finance.
Thus far, successful blockchain applications have taken advantage of these primitives in servicing the ‘long tail' of both users and assets. Some illustrative examples include:
- Uniswap: Traders don't use Uniswap to trade ETH/USD, but it is THE destination for all long-tail small cap tokens.
- Aave: A high net-worth individual based in the US would turn to a private wealth manager to borrow against their assets, but a crypto holder in Argentina might utilize the decentralized lending markets on Aave to take out a line of credit against their crypto balances. While it may be tempting to envision all products existing as public goods on the blockchain, we do not believe that products should be built on-chain just for the sake of “being on-chain.” In a similar vein, we also think it's a mistake for protocols to strive for complete decentralization of governance as a first-order priority, without first focusing on the core viability of their product.
Instead, we ought to have a sound rationale for building on-chain, with deliberate consideration of the product tradeoffs that make blockchains the correct technology to use despite their severe limitations.
Building on-chain marketplaces is hard, and the vision of fast, efficient, and scaleable decentralized exchanges has remained elusive. Despite the lack of recent progress on the application front, core technological primitives continue to advance: scaling solutions for Ethereum, institutional-grade wallet infrastructure, new L1s, and improvements in oracle infrastructure are being built as we speak. As new primitives are unlocked, the design space will open up for the applications and builders able to utilize them.
In the next part of this series, we'll review the existing attempts at building on-chain options marketplaces and discuss their tradeoffs.