Zubin Koticha: Opyn – The Release of V2 #385

Transcript

this is epicenter episode 385 with guest zubin koticha of open hi this is piedrique ernst and this is sunny agarwal and we're here with zuban kutica of open to talk about open version 2 today hi zubin hey hey everyone how's it going so happy to be back on on epicenter yeah it's super it's super nice to have to have you back so before we talk about

open we'd like to thank our sponsor for this week's episode the this week sponsors paraswap pariswap is the fastest and most liquid dax aggregator on the ethereum blockchain its state-of-the-art algorithm beats the market price across all major taxes and brings you the most optimized swaps with the best prices and lowest slippage check out paraswap dot io slash epicenter and claim 50 gas refunds for a swap of at least one eath traded so zubin we didn't actually have you on that very long ago i think it was last summer um since then you have released open version 2.

let's talk about how version one faired first so in in a very small nutshell can you kind of remind us how open version one worked right so open version one which is actually still live because uh ethereum and is still trading for assets like uni and smaller assets was really built for insurance so the high level is if you are kind of in an insurance mindset what you want is to ensure that any assets you have on a protocol will be safe right and what that means is that you'll able to get

their fair value for them so if i have a hundred dollars in compound and compound gets hacked i want my insurance to pay me a hundred dollars the way we did this in version one was that we said what if we give people put options which are really commonly used as insurance in traditional finance what if we gave people put options on their c tokens so on the actual deposits and compound and so in the normal case you can take your c tokens which represent your deposits in compound and go to compound and say hey can i have my hundred dollars back compound

will give you 100 usdc back but if that failed you had this option to sell your c tokens on open for exactly a hundred dollars and so even if you couldn't get a hundred dollars from compound you could get a hundred dollars from your open option that effectively was insurance on on assets insurance is still an extremely interesting and huge use case uh in crypto uh and especially on chain but what we found very quickly was a lot of our users were really excited about being able to hedge financial risk um and that was much

better done through a traditional options infrastructure and so we moved from using options for insurance to using the financial insurance part of options along with other options use cases in a much more broad way and that was what kind of informed and motivated the development of v2 um and so v1 was extremely successful um after kind of pivoting from pure insurance to options uh we had more than 100 million dollars of volume in the first year and people traded options uh on assets like uni on on wi-fi and on comp

before they were ever tradable anywhere else so those were some of the first ever derivatives trades that happened on some of the most important and fun foundational crypto assets was the insurance really going to be your like final use case or were you kind of always intending to move towards this more financial options thing and was the insurance more of like a way of explaining it to like you know i feel you know if you go rewind like a year maybe a lot of people in d5 didn't even understand options and was insurance just a good way of explaining to them how it works and this was always the long-term goal or was this something that like evolved as the market evolved as well it's a great question um so i think

options have always been interesting and they've gotten way more interesting in the last year uh i think i'm not sure that i was on uh like near the time of black thursday last time and since then options have been like such an interesting and foundational uh part of like this new wave of of the financial system you can see things like the gme like gamma squeeze as such an instantiation of that um and we can get into that more at the time and still to this day options are a huge use case and getting bigger and so is insurance but at the time we were really focused

on insurance so our first use cases were like compound deposit insurance and you had hugh from nexus mutual at a similar time and it's very clear that nexus mutual has been doing incredibly well uh and there is a big demand for people to protect their assets from hacks etc on chain um and so that was really the original use case but it's it became very clear very quickly that our infrastructure was even better poised to support options and v2 is a 10x improvement in that direction built specifically for that use case rather than

for the insurance use case so so that use case being hedging financial risks or something else yeah the use case is hedging financial risks and being able to uh make certain bets using options in general um rather than like the pure insurance use case can you give an example um of a primary use case that you see for options right now so basically where would i as you know your very average d5 user um come to use options and what for yeah this is a great question so let's

start with the use case that most similarly reflects the insurance use case which is financial risk so right now we're at a pretty kind of frothy point for the markets things are going pretty well you know bitcoin passed 50k um and it's very kind there's a lot of optimism and so we could see bitcoin 100k we could see bitcoin go down it's it's very unclear right and so is is this a top is this not well i think most people in crypto want to continue to hold crypto assets but they also are aware that there is these cycles that crypto goes through at pretty you know continuous intervals of going up and

going down if i bought a put option on bitcoin or rap bitcoin with a strike price of 50 000 that means that and i also hold bitcoin on the side that means that if bitcoin goes up i have all that upside and so i'm still like 100 long hauling if bitcoin goes down below 50k my option my put option gives me the right to sell bitcoin at 50k no matter how low it goes so if we see 20k uh bottom whatever we see i'm capped in terms of my downside i

will not lose anything for every dollar bitcoin goes below 50 50k and so that's a huge use case people are using options for the other use case is trading volatility itself and so what options and generally non-linear instruments which is what an a non-linear derivatives which is what uh an option is since it's non-linear in its payoff it has convexity um right what i mean by convexity is that i have infinite upside but i have capped downside so an option contract effectively is because it's non-linear it doesn't

just matter if you know ethereum or bitcoin is expected to go up 10 20 over the next year that is somewhat relevant but even more relevant is how volatile will bitcoin or ethereum go up because with a non-linear instrument like an option if i make money if it goes up and i don't lose money if it goes down i want the underlying asset to be as volatile as possible because no matter how low it goes i don't lose anything and if it goes up insanely much i gain a lot right and so the wider the distribution of final prices the more that option is worth that that

assumes you have a basket of options right like if you have one option why do you want high volatility so uh it doesn't matter if you have a basket of options or even if you have one option every option has something called positive uh va has positive vega that means that it pays you money uh and it goes up in value if there's a lot of volatility in the future so the way to think about this is like let's say there's only two prices bitcoin can take a year from now right uh and one price i have an option with a strike price of let's say fifty

thousand dollars okay which is what bitcoin is at right now and bitcoin at the end of the year can take a price of a hundred thousand dollars or zero this is called the binomial option pricing model we're thinking of it in terms of binomials there's two possible values you could have in the future so if bitcoin ends the year at a hundred thousand dollars my option gives me the right to buy bitcoin at 50 which i will obviously exercise i would love to buy bitcoin at fifty thousand dollars if it's trading for a hundred thousand dollars on the market but if bitcoin goes down to zero my option is worth zero right and so uh no matter what

uh no matter how low it goes below fifty thousand dollars it's it's it's zero so i have let's say a 50 chance of going up to a hundred thousand dollars and a 50 chance of going down to zero my average payoff of this option is 25 000 right because 50 chance the option is worth 50k 50 chance the option is worth zero so if bitcoin could take a price of a hundred thousand dollars or zero what if bitcoin had less volatility let's say with fifty percent chance it ends the year at sixty thousand and fifty percent chance it ends here at forty thousand

well my bitcoin option my call option still has a strike price of fifty thousand dollars so it's either worth ten thousand a year from now or it's worth zero so basically its value should be uh five thousand dollars so the wider the final distribution of prices is the higher priced options are so any option will gain value uh as a result of volatility so this is extremely useful to to traders because you can use option prices

to figure out what the market expects volatility will be in the future and this is called implied volatility and so wall street's fear index is got something called the vix right and so people look at the fear index to figure out how scared is the market how volatile does the market expect asset prices to be in in the future and in times of distress like black thursday in the early uh kind of days of the covet crisis vixx spiked um and so traders that held options or traders that held vixx were able to hedge them hedge their risk uh

as a result of future volatility what does that mean to hold pix uh so vixx is an index that's built from option prices and so another way of saying hold vix means that you're kind of betting that volatility is going up in the future and there's a bunch of etfs exchange traded funds uh that let you do that in in traditional finance pretty easily and they're they're very liquid but crypto doesn't have something like that and so that's a huge use case and you can imagine how volatile crypto is that's one thing that makes it so interesting from like a financial markets perspective so that would be hugely helpful can i just put in there

so if you apply this again to me as you know your average defy trader um of course it's it's interesting to me to see what the market thinks how volatile um this ecosystem currently is um but how would trading on on these financial instruments benefit me personally more than say buying futures right so futures are really cool uh in that they allow you to take very leveraged bets on on the price of the underlying but they don't allow you to trade volatility itself so what i mean by this is there's billions of dollars of value traded in

traditional finance of people who are literally betting volatility is going to be a hundred percent per year next year or like no it's going to be 70 and one of those people is going to make money because they're going to go long volatility and one of those is going to lose money and so a defy trader that's very savvy will be able to uh make a lot of alpha and generate returns by betting on volatility and being potentially right so that's one entire use case but basically if someone bets on volatility someone has to bet against volatility right so basically this is very much a zero-sum game so i would expect that not to be a huge market for this

so typically if when you trade in the market you expect the entire market to go up over time so basically there's a there's an upside for everyone i mean on average of course um but for these assets where you have where where to for for someone to be a winner someone else has to be a loser um those typically don't scale as well do they actually they do so the options market right now is a 300 trillion dollar market and generally derivatives markets are almost all zero-sum so if you think about an interest rate swap right one person is literally paying

and one person is getting paid and so it's exactly zero sum uh a futures market is the same where one person is going to lose money at expiry and one person is going to gain money and these markets are far larger than the underlying markets in in traditional uh finance the reason why they're so big is because even if someone loses money on the derivatives trade themselves they might be using that derivatives trade to hedge a bigger position they have elsewhere and so it's possible uh that you know even if it loses money it's part of a larger portfolio that still gained money uh due to fundament fundamental value know most

people booked flights on travel aggregators to get the most options and best prices for their travel plans so when you're making defy swaps use paraswap to optimize your trades with low slippage pair swap beats market prices across all major decks this is thanks to pair swap pool a network of professional market makers that offer the best prices across dexas with zero slippage pair swap is dead simple to use and it's growing fast they're constantly adding new features and integrations and soon they'll release the v4 algorithm which is faster and cheaper to use in fact you might already be using paraswap without realizing it since metamask arjun and monolith all rely on the periswap api so give parashop a try at dot io slash epicenter

and when you use that url you'll be able to claim a 50 gas refund on your first swap of at least one heath this offer is available until may 1st and refunds will be made every friday starting april 9th we'd like to thank paraswap for their support of epicenter okay so before we actually dive into um v2 v2 and how that how that's different from v1 um maybe i can i can pull ahead a question that kind of fits in nicely here so if you look at options in the d5 space they haven't yet found a large amount of traction right so basically seeing that you're so so bullish on them and seeing that

they apparently have a large amount of traction in in the in the legacy financial system um what do you attribute that to right this is also a very interesting kind of area to dive into um so i think i'll first talk a little bit about options markets in traditional finance and there's kind of a third use case we haven't talked about yet which people will find i think the most compelling and then go a little bit into crypto and then d5 so i think you know as i just mentioned options are a 300 trillion dollar market every single year which is way bigger than the stock market and what's really interesting about

options is how much they've grown in terms of retail interest and so users on wall street bets it's very clear that they use options to make these very outsized highly leveraged position trades as well as to buy puts to to hedge their downside and so that's been a very large growth story in in traditional finance um and increasingly if you look in traditional markets the percentage of options volumes that is traded by retail investors has gone up with time so it's starting to become more democratized in a sense and that has

lots of kind of different effects on on the financial market structure that that are interesting and yet to be seen uh but it is a bigger and bigger part of the narrative of traditional and legacy finance uh markets and what's interesting is that options are even bigger than futures in traditional finance they're more than seven times larger as a market but in c5 and crypto they're still much smaller right they're less than uh five percent of futures volume and the reason is they're just so much more complicated kind of as i described there's a non-linearity there's all these greeks which means

that there's like five different variables that affect an options price and each one uh will affect it in different ways and that's what the greeks represent and you use black scholes and all these very complicated formulas binomial option pricing model to figure out what an option price is and so getting market makers to market make these in size is increasingly kind of a difficult thing especially in a market that's as complicated and as volatile as crypto but we're seeing really big growth um and derebit now you know used to do less than

you know 10 million dollars a volume a day is doing uh more than a billion dollars of volume of volume a day on good days so uh for options so it's very clear that there's the the growth story in c5 and bitcoin options are becoming much much bigger but i i would agree with you i think in d5 there's still a lot of room to grow right and if we look at kind of uniswap volumes and we look at perps and futures volumes those are kind of way bigger than option markets indeed in d5 so far if we look at the way that defi trading kind of emerged though it started with spot

volumes going up there was a time where there was almost no dex volume in d5 but then amms came about uh and we started to see so much spot volume and then we saw perpetuals be huge on bit max and on c5 but not yet on d5 and now those are starting to grow a lot and i think that just because of the complexity of options they are just so hard to get right we're seeing a lot of growth now right we've gone from zero to 150 million dollars of volume in less than a year but that's going to continue to kind of compound at a massive rate in in the future and going to eventually eclipse futures volumes if d5 goes the way

of c5 and legacy financial system so so what's your strategy of how you guys are like you know maybe helping accelerate this is it are you trying to educate current crypto and d5 people on options or are you trying to bring in the expert options traders from the legacy world and bring them into crypto right there are a few challenges that remain for getting either of those user groups onboarded uh in d5 and i think that it's more than just you know a matter of time and getting the people interested right now we're in a position where

lots and lots of people want to trade options in size they want to make really big bets they want to hedge positions and they want to trade millions of dollars of notional uh and you can imagine especially whales that are more kind of financially savvy want this kind of product but there just isn't the market maker volume yet and there aren't kind of the mature amm infrastructure yet to service that kind of demand and so right now i think it's less of a question of bringing people into defy options world uh from like a demand perspective and more bringing liquidity in from the supply perspective

and so that's what we're focusing on right now and then the other big thing that we're focusing on right now is just the rea reality of of how expensive it is to trade uh on chain right and so if you're selling options you're trying to get yield right you're trying to get a premium for selling that option to someone and if you're paying 200 300 to do that and you would have made you know 500 to 1000 of premium for that month it really it eats into your profit significantly so the really big things to solve in order to get options volumes uh into a serious kind of

part of the d5 infrastructure is liquidity and and like some of the gas questions and so layer two uh etc on that so that makes sense for a lot of the defy stuff right but what about like dare like you mentioned like even derebits volumes are lower than bit max perps and stuff right but like as we mentioned the volatility in crypto is probably higher than traditional financial markets and shouldn't that be attracting all of the like trad buy options traders to darebit but why hasn't that happened yet yeah that that's a great uh question so i think the there's a few reasons for that the first is

we're seeing options volumes grow extremely quickly to the point where yes derebit is still doing less options volume than bit max is doing purpose volume but the growth is very much there and very and and kind of staggering so i think it's just an eventuality not necessarily that we're going to eclipse perp volume because perps are this kind of new and very interesting derivative that doesn't really have an analog in in traditional finance um but we're definitely going to see like this this compound interest not compound interest but compound eight rate of growth for

options markets that will leave us with really large markets in the in the long run there so but how do we get there i think that it's going to require a lot of the more professionalized market making infrastructure and firms to become comfortable with some of the risks so some of the custody related risks oracle related risks counterparty related risks i think another thing to keep in mind is that the markets for derivatives in the us especially are very formalized so there's clearinghouses a bunch of infrastructure for banks to talk to each other a bunch of

infrastructures as finance for like financial insurance in case like an exchange goes under and a lot of that formalism kind of needs to come into this d5 there's not even d5 but a lot of this formalism needs to come into c5 before that's attractive for for traditional and legacy market makers to to take it seriously but i think it's just a matter of time it so so cool um so i i'm all for talking about caveats and pitfalls but um i i would suggest we kind of put the host before the card so let's let's talk about uh version two and how that's

different from version one first zubin could you could you explain what kind of changed in this upgrade right so the goal of open version 2 is to be the most capitally efficient uh and powerful options protocol in d5 and the way we do that is a few kind of routes we tackled the first is make user experience way better and there's a few things we did for that the second is pure capital efficiency improvements um and we've gone after that as well and the third is developer experience so when it comes to user experience in version one of the protocol and i think

this is something sunny talked about they were physically settled options so if i wanted to uh if i wanted to exercise my kind of you know bitcoin call option that i talked about earlier let's say bitcoin is one day trading at a hundred thousand dollars and i have a call struck at fifty thousand with a strike price of fifty thousand that means that i have to the right to buy bitcoin at fifty thousand dollars even though it's trading at a hundred thousand dollars on the market and in order to exercise that there's two ways that i could do it the first is through physical settlement

which means i literally come with usdc or dye or tether or other stablecoin and i exchange that with one bitcoin that my cop my counterparty gives me and so there's these physical assets that are delivered and a real trade happens and you can imagine that this is this can work in in c5 pretty well but in d5 there are a couple of problems the first is it's a huge liveness requirement for the user and so you can imagine a user just wanting to like fire and forget and if their option is in the money they don't have to necessarily pay the gas costs uh to to exercise that so that's the

first thing and the second thing is it really makes it harder to create perpetual strategies kind of like the vix that i talked about crypto vix that i talked about because there needs to be a literal exercise event and then also on top of that it's a if someone forgets to exercise they actually lose all of their money and so that fifty thousand dollars that they would have gained from that option that i talked about if bitcoin expires at a hundred thousand dollars and they have that call at fifty thousand they would like have just lost all that money if they weren't able to get their transaction finalized in time and so it just adds like a real

big amount of stress for a user so in v2 we've reimagined it and made it cash settled and so what that means is using a oracle price you can figure out what the difference in price is between the underlying asset and the strike price and you just give that amount to the person who is exercising without them having to exercise actually um and as you can imagine that requires an oracle price for the this the price of the underlying but it's also very powerful because it makes user experience way better especially in

d5 so the trade-offs that come with that uh are that there's some reliance on on an oracle price right um so that's one potentially point of weakness that it has but there are many improvement points as a result the first is also like this capital efficiency point of view earlier you would have had to probably either have a flash loan or actually find a way to get fifty thousand dollars of ustc in order to make that position uh exercise but here you just need to you just when the option expires you can just withdraw uh 50 000 so these are some of the kind of trade-offs

that that exists with cash settlement is it also now more permission of what types of options you can create like in like v1 because everything is physically settled let's say i wanted to make an option for like you know sunny token and the underlying is in zubin token right these are like random again because you mentioned earlier that like v1 is still being used for like other assets like uni and things like that because in v1 it's in physical settlement it seems like anyone can come along and create an option for whatever they want in v2 is there like more limitations like you know now you have to have oracle you have to have running oracles for everything and like

so is it more limited on what people can create options for yes uh it is a little bit more limited in terms of what people can create options for in the sense that there have to be a very solid oracle price but this is actually something we kind of anticipated and it's one of the reasons why v1 is still chugging along but it's also something we feel really bullish about um is the fact that there's going to be really good oracle infrastructure for derivatives markets so you can imagine that most of the derivatives markets that are going to be there in d5 are uh going to be people trading derivatives options

futures etc on assets that have liquid spot markets and if they have liquid spot markets they're probably on either uniswap or some other amm and especially with uniswap v3 uh the ability to create oracles on pretty much any spot market that are relatively secure articles has gone up massively and so basically if there is a liquid spot market for it then there will be a liquid derivatives market for it uh and and also a good oracle for it so super houses checked so basically if if i want to go ahead and create some sort of options contract how do you

check that um there's actually good oracle for that right so for right now it's still uh relatively permissioned but the goal is within the next year to get it to a place where you can have literally thousands of different types of options contracts trading and i think there's different ways that that that can be done and i think the goal would be for some kind of governance framework to to start thinking about that but i think you can look at liquidity levels um and democratization of liquidity in amm pools so uniswap pools balancer pools etc and use that as a

proxy for a t-wap oracle uh being being good the one caveat there is that you need to make sure that the spot market is really large enough to prevent manipulation um but that's starting to become increasingly true uh where you have these really really liquid and deep spot markets in indeed in d phi you just said that current d is still relatively permissioned what do you mean by that so what exactly is is the level of uh permission that i need so you don't need any permission to create an option if the oracle price already exists

so for example right now we have ethereum options trading you can launch any eth option that you want but if you want to be trading uni etc v1 is still better for now but so in order to add a new oracle for a new asset that right now is a little bit of a process um for v2 so you're curating the oracles as open yeah okay i have a couple of questions around oracles but maybe we can we can answer them in the pitfalls section that i look forward to so can tell us a little bit about some of the other methods of capital

efficiency you have so there's uh one one of the other pieces i know is you now have the ability to collateralize positions using other options themselves so can you talk a little bit about how that works and what that even means so there's two kind of goals that we have when it comes to capital efficiency the first is to allow people to use options as collateral for other options and in doing so build this gigantic like kind of network of o tokens which all can interact in these interesting ways and that's really weird and interesting because you could have three different types of long options you're using to collateralize

a vault that you have for a different type of option then the second part is for naked options positions which means that options that don't have any collateral which is o tokens can we get the collateral down to a place where we'd say we're partially collateralized so uh right now if an option requires 100 usdc of collateral can we get it down to things that would be reasonable in c5 so can we get it down to like thirty dollars or twenty dollars or ten dollars and so the first part of that is through something called options spread trading so a spread in the options world is when

you're buying one option and you're selling a different option that's very similar the only difference is the strike price right and so let's talk about selling options for a second because selling options is a little bit uh kind of more involved than buying options let's say i wanted to sell this call option we've talked about where bitcoin with a strike price of 50 000 right now if bitcoin goes to infinity if it moons then my loss is potentially also infinity right in dollar terms but my dot my losses capped at actually

exactly one bitcoin right and so if my loss is capped at exactly one bitcoin that's still a lot of risk right and as a result the amount of collateral i need is like 50 000 which is exactly one bitcoin but i could use an option that i bought a different call option to collateralize my uh 50 000 option so let's say i'm selling this bitcoin call option with a strike price of 50 000 and i need you know one bitcoin in order to collateralize it

if instead i came with i tried to collateralize it with a bitcoin call option that has a strike price of sixty thousand dollars right that means the difference between the option i sold and the option i bought the difference in strikes is ten thousand dollars and it turns out that ten thousand dollars is actually the maximum i'm i could lose from this position i can no longer lose an infinite amount of money if bitcoin keeps going up keeps going up i'll keep losing money from the call option that i shorted the call option that i sold but i'll also gain the exact same amount of money with the option that i bought so

when bitcoin goes from fifty thousand dollars to sixty thousand dollars i will lose ten thousand dollars but after sixty thousand dollars i own a call option and so i won't lose any more money and so i can collateralize that position with just ten thousand dollars rather than fifty thousand dollars so i've unlocked you know five x capital efficiency and so in a way that means like technically everything is fully collateralized it's just not being collateralized via underlying assets right it it is still 100 just with other options exactly exactly so v2 launched with full collateralization plus plus spread

trading and spread trading is using options positions that you have in order to create a more capital efficient portfolio on the on the portfolio level but it doesn't mean that you're ever like in a position of margining or liquidation so the goal is to become to kind of be at the forefront of d5 capital efficiency and have positions that are margined and liquidatable um and that's a something we're releasing in an upgrade very soon which is our partial collateralization upgrade uh which i can get into as well well why do you have to build that into

open rather than like saying relying on other d5 protocols to give people margin on their collateral and then allow them to deposit that well you don't have to but it's it's not like i have to or not it's like this is not doable if it's not built into open itself right if you want to unlock system level capital efficiency you need to actually build this into open itself so i think maybe to make that more clear i it might be helpful to explain exactly how this upgrade we're releasing uh and it's going to be sent to audit actually in the next few days as we're speaking right now but how this upgrade works so basically in the options world you have strike

prices right and as i talked about with like this bitcoin option let's say you have a strike price of ten thousand dollars or sorry fifty thousand dollars you need one bitcoin in order to collateralize it right because the maximum it could lose is one bitcoin um actually it might be easier to talk in terms of puts as well just to kind of add to it if you have a bitcoin option that's a put option with a fifty thousand dollar strike price you're essentially providing insurance to someone and you're saying like i will give you fifty thousand dollars in exchange for bitcoin right now in every single options protocol uh

in on chain in d5 you need to put down fifty thousand dollars as collateral and that's what we call full collateralization but the price of the option is not going to be fifty thousand dollars in fact it's not even going to be close to fifty thousand dollars let's say the option expires tomorrow that option might be only worth a hundred dollars so you're putting down fifty thousand dollars of collateral for a position that's worth a hundred dollars it's way more than uh you know 120 or 130 collateralization as you think about it when you think about it in maker or compound it's like a thousand percent plus

uh collateralization sometimes for these positions so what you ideally want is an oracle price for the price of an option and you want to make sure that you have some buffer above that and so let's say instead of wanting like fifty thousand dollars to mint this bitcoin option that's worth a hundred dollars you want two hundred dollars you want 130 140 dollars whatever is kind of reasonable the problem with doing the naive approach of using an oracle price for the price of the option is that there is no really reliable oracle price for every single

option that could exist out there in d5 so far it's kind of a recursive problem of you need this partial collateralization in order to have the liquid market uh that gives you the oracle price and then you need the oracle price in order to have the partial collateralization so what we need instead is is we need to figure out a way to have a upper bound estimate on what the options price could be without ever really knowing what the options price is and the way we do this is by using an oracle for the price of the underlying asset and applying some basic principles uh of black shoals

to figure out a upper bound that we're comfortable with but also an upper upper bound that is liquidatable so let's say there's a hundred dollar option we're able to calculate that um upper bound of price of this option option is 500 we're able to calculate that on chain without knowing actually what the price of the option is and then we say you need 2x uh of that upper bound in order to capitalize it and so you still need a thousand dollars rather than 50 000 to collateralize that option does that make sense yeah but there's a lot of assumptions

that go into this i would say this because i'm a physicist but um basically all of these financial market models they're governed by parameters that are kind of just set by experience right so there can always be a black swan event where where the model is actually wrong because the predictive power is low right so this is a great point right and so the idea is you need to take into account exactly what federico just said uh you need to have the built-in assumptions very clearly outlined but they also need to be assumptions that are very clear and are very kind of accepted to a certain extent so uh in d5 there are a few assumptions

that exist the first assumption that exists is that it really depends which uh which market you look at but it's something like eth cannot move more than 50 percent in the time it takes to do a liquidation so this is kind of maker's assumption which is actually 33 not 50 makers 1.5 x collateralization uh ratio uh that is required means that a liquidation can the assumption they're making is that a liquidation can happen before the time eth moves 33 right and so we use that as the basis for our uh liquidation methodology and our

partial collateralization but on black thursday the the prices fell so fast that that assumption was kind of turned on its head no exactly right so you need to have a strictly higher uh kind of amount than that but you also need to have the fundamental truth that if you want more capital efficiency improvements you kind of need to make some assumptions about the model and so you can get comfortable with the with the notion that there's like maybe 50 percent maybe 60 percent uh that each can move before a liquidation happens

but you kind of need some level of assumption in order to make that possible and of course we looked at the past and we look at black thursday uh etc to form some of these models but there is the only way to really have no risk is to never put your money on chain or to put like 100 of the strike price on chain but that's kind of uh untenable to have like if we want there to be a liquid options marketplace we need to make a set of assumptions that are that we're comfortable with in d5 are there going to be different tranches of options that form based off like what level of risk counterparties are willing to take

i think that might become true in the long run but that's not the goal for the medium term that is really interesting that you could potentially have two counterparties that trust each other uh entering into like a bespoke contract using open with a lower collateralization ratio um but the problem is that really hurts fungibility and so these like multiple different tranches of collateralization they also hurt kind of transparency to a certain extent uh because if you look at 2007 2008 financial crisis and you look at big short it was different tranches of collateralization and trust not just collateralization but also in

terms of creditworthiness that made it hard to follow exactly the amount of risk a user is taking when they enter into like a cdo for example and so we want to keep it as possible as simple as possible make the assumptions very clear the assumptions of our model is that basically eth cannot move more than uh 33 without a liquidation which is exactly like maker's assumption and everything else in d5 is more aggressive than that basically it assumes that eth can move only a smaller amount than that which is even more aggressive than us and then also implied volatility at the same time can spike

to no more than uh 400 or 300 per year that's still a parameter that we're going to have to set and then that's something that will be like set by decentralized governance in the long run but yes it is one of the core assumptions of any d5 protocol that does any sort of margining that there are some parameters set by governance that that are like that cool um another improvement that would be huge for d5 users is allowing users to use interest earning collateral right because opportunity costs currently are so big of you know setting setting capital aside uh and have it be idle so is that coming to open as well

right yeah so that's something we built v2 uh with the ability to do so rehypothecation is like a fundamental part of of legacy financial system that also unlocks capital efficiency because in order to sell options if you're still getting the interest you would have by putting your money on compound or somewhere else then your opportunity cost is way lower and so that's something we built v2 with the ability to do the thing there is that governance needs to decide and right now uh we are kind of still in the process of decentralizing and that's going to be something we're doing over like the next year

but it's up to governance when we give up governance to the community to decide what specific interest-bearing assets they want to uh allow um and so you know because every single interest-bearing asset has a different risk profile and so that's something that's really exciting about v2 but also again there starts to be these these risk metrics uh that the system in a whole has to govern and and take care of uh which which will be interesting to see cool and then as how much um will open v2 be will kind of determine how the option lego bricks are shaped right because so basically if you say

well a lego brick has to have like six pins and you know four holes or whatever i mean that's kind of not not nearly specified enough so basically what i'm getting too is if you want to achieve fungibility of different options so basically being able to collateralize um something with a put or a call option of the same shape or form however you want you you kind of need to ensure some basic um interoperability right so basically things like which articles are you allowed to use um how how collateralized do things have to be and so on and so basically there's a trade-off

in giving giving the users freedom in the first place and then kind of ending up with all these disparate options that you can't really use together so how how are you how are you moving um in that in that field that's a great point um and when we originally wrote like the convexity protocol paper that was something we thought about really deeply is you want to maximize standardization fungibility um in order to make sure there's like a liquid and fungible options pre uh a marketplace that that forms and so the way that we're thinking about that is

and it's kind of the reason that we are still focusing on just like eat options that are like at the money or near the money and with a few specified kind of experience that's the first way you ensure fungibility but the real way to ensure fungibility is to create a single asset that represents a perpetual position on options that someone wants to take and that one asset that is uh completely is one that is like continuously rolling over and rebalancing to create some kind of desired property and so

something i talked about was vixx right and so vixx is in the legacy financial system an example of taking a highly disparate set of of options i think that they do like 30-day options and they have both puts and calls straddles that are like at different price and in doing so they have like you know functionally thousands if not tens of thousands of options that have contributed to a single asset called the vix and that's one way to create fungibility in the options marketplaces is to create kind of strategies

systematic strategies that buy options at like or sell options at pre-specified intervals at pre-specified prices near the spot price away from the spot price if you can reduce that massively complicated problem space into a single asset that would be really cool and so that's something that we built v2 with that in mind we were thinking about how do we create a way for developers to create these systematic fungible strategies very easily and the way that you do that is through something called an operator so an operator is a

a kind of special permissioned uh actor in the open ecosystem a user can decide whether or not to give an operator access and when i say permissioned i mean anyone in the world can be an operator and any developer in the world can create an operator smart contract but a user decides whether that operator smart contract can essentially roll over their funds can rebalance their portfolio can deal with their margin after an expiry um and so if someone wanted right now to create vixx for crypto uh and make it liquid for the first time in d5 they could

build an operator smart contract that did exactly that for open so that's how you create fungibility out of like this really complicated problem space of options obviously there's a lot of like really cool features that went into open v2 how does this compare to like you know i was joking earlier with someone that like seems like there's a new options protocol on ethereum every week and like building an options protocol seems to be like the hello world starter kit for like how to learn how to do solidity development and so like what makes open different than you know we have all these other platforms like you know like some of the popular ones are like hedging and stuff but you

you're seeing a lot more and more come out over time uh what makes open differentiates it yeah i think that's a testament to just how big options are gonna be is seeing like the amount of interest that's coming on from the dev side in terms of options at the end of the day no one has really solved this yet and so what i mean by that is until someone can reasonably make a really really large trade like a 100 million dollar size trade which is very routine in both c5 and in traditional financial system or until you know literally tens of thousands

of uh smaller users can make trades until that's like a reality in d5 i think it's still like a race to whose cracks the code and i think there are a lot of very interesting different models out there and i think that the more different models there are we actually welcome it because fundamentally we've been in d5 for so long uh we just want to see the success of defy uh and this success of really cool new derivatives markets that are enabled by like a programmatic developer first financial system but no one has solved the problem yet and so the ways

that you could solve the problem are are in many different ways and we're seeing the different philosophies there our philosophy is that people need to be able to buy and sell options in size at a good price um and a lot of and and that the best way to do that is by making trades really cheap so that's kind of moving to l2 in the next few months which is something we're starting to do really seriously uh and then the next thing is by having an amm where users can both buy and sell from the amm

also very easily which something that no one has really done in a liquid and successful way yet um and so the reason we feel that we're kind of ahead of the pack when it comes to that especially that second point um is just the kind of ideas that were we're forming in some of the technology that we have and the people we're working with it's just really cool to see and there's like a lot of optimism internally that we're going to be uh kind of the first to crack that extremely difficult puzzle and i can talk about a little bit some of the ideas that i have there as well yeah absolutely i have so many questions about the amm but before that i have a short one so which l2 are you looking

at yeah we're looking at tons of things i think that when it comes to just a trading infrastructure for people to like buy sell options and exercise um options we're looking at you know zk roll ups uh are very promising from that point of view um but what do we want when we talk about like having the entire infrastructure the margining system partial collateralization and amm trading all that stuff looks like it needs to be done on some kind of optimistic roll up i'm pretty bullish on the idea of like being able to take something that looks very close to solidity code modifying it very slightly and having a

very similar experience for users and i think like everyone else who's building a d5 would be feeling similar and that's one reason that something like optimism where the ovm is kind of based on the evm is really compelling but we're still in a space in 2021 uh in in march 2021 where no l2 has won out clearly so super open-minded when it comes to that cool i look forward to seeing what what option actually wins talking of amms so actually building an amm for um an asset that has a correct price at a certain point in time is actually i would have said impossible but

basically you you basically what you said earlier makes me think maybe you've maybe you have thought about something that i haven't thought about yet so i mean basically the the thing about amms is impermanent loss and in the case of options or other things that clearly have a right price at a certain time um this impermanent loss becomes very much permanent loss um so basically because there's an information asymmetry between a dumb bot and a sometimes not as dumb trader the the amm liquidity provider should lose but it sounds like you you you kind of figured something out here so let us in on that to put that into

simple terms that maybe people can understand i think that what made it obvious for me was like you know you can take something like an option and if it expires out of the bunny the value is zero and on unisop if you have a you know eath versus these like options and the value of the options go to zero then everyone will just take their worthless options and sell them to the pool and withdraw all the eat from the system and the liquidity providers are left holding the bag of these zero value options yeah exactly so on uniswap which was like the first place where open o tokens were trading where options were trading you got really really bad impermanent basically permanent loss

from drift due to the option marching forward towards its expiry towards its maturity right and as it marches towards expiry if especially if it's out of the money that means that it's going to be completely worthless and so you have this drift that is very clear that's going to just destroy the the lps as sonny just said the thing that is interesting though is that uniswap empirically works very well for a spot market where drift is minimal so if you have an eth usd option uh you find that the drift between eth

and usd yes there's like tons of volatility but it's not like eth is always like going to expire at like zero or something the way that you would have for an option and so in fact even if a liquidity provider in the ideal case is able to provide liquidity at a specific price and take out liquidity at the same price then they're almost guaranteed to have made a profit so that's how we started thinking about options uh and amm design we were like hmm yes the price of an option goes down over time this is called theta decay and it's the greek that represents how

much an option goes down in price over time so that's a drift we know about ahead of time is there another parameter which actually for an option is expected to be constant over time in the absence of any kind of new information and options are actually not really priced in terms of dollars when traders price options and think about options and say like can i buy an option from you here's the price that i'll pay they actually talk about it in terms of implied volatility or vols right and implied volatility is like basically when you use black trolls you you back it out uh from black shoals but it's the way that you compare

options against each other and it's the way that you really inherently price an option in terms of falls so the idea is could we say that the implied volatility of the option is staying constant and that's how we're pricing the option in terms of its implied volatility and so over time even if theta decay kills the value of the option implied volatility is constant and so the price for offer in dollar terms should go down with time so this is very similar to kind of the yield space idea uh yield space is a paper from uh dan

robinson uh and uh and a few other folks lev about kind of how to build an amm when you have interest rate drift so if you have a y token which is a zero coupon bond that's drift you know about ahead of time what they did is they took the idea of an amm and they flipped it on on its head and its head and said wait we're not trying to figure out what the price the zero coupon bond is in dollar terms we're trying to figure out what the price the zero coupon bond is in interest rate terms we're going to hold interest rates

constant in the absence of trades any trades that buy the uh the the zero coupon bond will make the interest rate go down and any uh uh trades that sell the zero coupon bond to the pool will make the interest rate go up and in doing so we'll have this predetermined drift that's nicely taken care of uh for us we instead of trying to price you know like bonds are priced their inherent uh way to price and compare bonds is in terms of interest rates and not in terms of dollars similarly in the options world the way to compare options is in terms of vols and implied volatility and not in dollars

and so you can hold that constant and have that go up and down based on a constant product and that's kind of an idea that we came up with towards like late summer last year turns out it's like really complicated doing black shoals on chain blacking it out backing out volatilities from black shoals figuring out exactly what slippage function is how steep it is but we're we've made significantly significant headway when it comes to that uh and have some really kind of exciting ideas there as well so i know currently you guys are actually not using an amm at all you guys are actually using xerox to uh do a lot of your market making

is that because yeah what's the reason for doing that right it's because the kind of current amm infrastructure that's not purpose built for options has the exact problem federica mentioned where you have permanent loss and the options are just so leveraged and so complicated that a very kind of naive spot amm is almost certain to lose a lot of money and also fees are not high enough as well as a percentage of premium so the idea is the only terrible way to have like a large market maker volume on chain is to have

uh a centralized order book model until you have like the amm and so that's the stop gap measure on the way to the amm and i think in the long run as we see market participants get more sophisticated as we figure out l2 solutions we're going to have lots of order book volume uh for uh in d5 for options it's it's something that we see in traditional markets and so there's no reason we wouldn't have it be also like a large part in addition to the amm on on chain so so what's the what's the time frame for the amm when can we expect to use this yeah i think amm that's a really good

question and really hard i can't really promise any dates because it seems like we really want to want to crack it in a very elegant and easy to understand way just because the complexity of something like an options amm means that if there's any sort of issues uh it would be it would be catastrophic for a liquidity provider which is one thing that gives me pause with a lot of the other amm designs for options that are out there it's very clear that there's catastrophic flaws in them uh and i i don't mean that in like is an insulting way i think they're really cool ideas out there it's just such a hard problem

um so i can't give you an exact date but let's just say in the next we will be able to we'll definitely be able to have an amm before l2s are big in ethereum and way way before east 2.0 is a thing so it's definitely like way before you have the ability to have massive order books uh dealing with a majority of volume it you'll will have uh is my estimate of when we're gonna have super liquid amms for options i i feel like you're doing this nesting collateral thing here where you answer my question by you know like inputting another parameter and saying

i don't know but before that parameter okay anyways i think this is this is probably a good way to wrap up thank you zubin for coming on and uh i look forward to using the new amm i think this is this is going to be a huge thing if it actually works out yeah so so awesome to be here and so excited to be kind of uh working closer with the every center team uh when it comes to doing my own interviews so fun to be on the other side of it as well uh and as always it's it's really fun to chat with uh with you sonny and thank you for joining us on this week's episode we release new episodes every week

you can find and subscribe to the show on itunes spotify youtube soundcloud or wherever you listen to podcasts and if you have a google home or alexa device you can tell it to listen to the latest episode of the epicenter podcast go to epicenter dot tv subscribe for a full list of places where you can watch and listen and while you're there be sure to sign up for the newsletter so you get new episodes in your inbox as they're released if you want to interact with us guests or other podcast listeners you can follow us on twitter and please leave us a review on itunes it helps people find the show and we're always happy to read them so thanks so much and we look forward to being back next week you