- Convexity Protocol establishes a generalized framework for fungible ERC-20 tokenized options contracts called oTokens
- Tokenized options contracts allows for a wide range of sophisticated trading strategies that are present in traditional financial markets.
- The protocol allows users to earn premiums on their crypto asset holdings by minting and selling oTokens on the open market.
In 2019, we’ve seen the emergence of multiple new lending markets, decentralized exchanges, and other financial applications. However, despite the immense growth in DeFi, the industry has yet to see a prominent application absorb one of the largest legacy capital markets in existence to date. It is estimated that the derivatives market is valued at over $540 trillion in notional contract value. With this, options contracts are one of the most widely traded derivatives products in traditional finance with an estimated annual volume of over $635 trillion. Generally speaking, liquid options contracts provide investors with a wide range of sophisticated trading strategies. As such, we can imagine that permissionless, non-custodial options contracts will be a vital step in the maturation of DeFi in the coming years.
Fortunately, on November 12th, Zubin Koticha published a whitepaper for Convexity Protocol and oTokens. This DeFi primitive establishes a generalized framework for fungible ERC-20 options tokens on Ethereum.
A Brief Primer on Options
For those unfamiliar, options are a derivatives contract that gives the owner the right (but not the obligation) to buy or sell a specific asset at a predefined price from the option writer. Traditionally speaking, options typically represent 100 shares of the underlying asset where the buyer pays a premium for each contract. Premiums on the contract are largely based on the strike price (and whether the contract is in-the-money versus out-of-the-money) and the time until expiry. With all of this in mind, you can calculate the price of an options contract as follows:
total = number of shares * premium
As a brief example, let’s say there’s an options contract with a premium of $0.50 where 1 contract represents 100 shares of the underlying asset. This means that to purchase 1 option contract it will cost $50.00 (100 shares * $0.50).
As you can begin to imagine, there’s plenty of terminology with options that are important to understand for getting a complete grasp on Convexity Protocol and oTokens. Therefore, we’ve compiled a brief glossary on some of the terminology used when using options.
Call Options: An option contract that gives the buyer the right to buy the underlying asset at a stated price within a specific timeframe. By owning a call option, you’re long on the underlying asset.
Put Options: An equity option that gives the buyer the right to sell the underlying asset at the strike price per share. By owning a put option, you’re short on the underlying asset.
Expiry Time: The time and date at which the option expires and the buyer and seller are relieved of their rights and obligations.
American vs European Options: American options allow the buyer to exercise the option anytime before the expiry time. European options allow buyers to only exercise their option exactly at the time of expiry (at no point before or after).
Underlying Asset: The asset that the buyer has the right to exercise.
Strike Asset: The asset that the buyer receives if he exercises (only used with complex oTokens contracts)
Strike Price: The pre-agreed price per share at which the underlying asset may be bought or sold under the terms of the contract.
In-the-money: A call option is in-the-money when its strike price is less than the current underlying asset price. A put option is in-the-money when its strike price is greater than the current underlying asset price.
Out-of-the-money: A call option is out-of-the-money when its strike price is greater than the current underlying asset price. A put option is out-of-the-money when its strike price is less than the current underlying asset price.
Convexity Protocol proposes a generalized protocol for options contracts on Ethereum. Options contracts are minted in the form of fungible ERC-20 tokens where all oTokens are fully-collateralized by any arbitrary crypto asset (think ETH, DAI, USDC, etc.) with a handful of key parameters set upon minting. These parameters include determining the underlying asset, strike price, expiry date, options type (American vs European), and more.
By enabling a completely open and permissionless protocol for options contracts, participants can mint oTokens by locking up collateral in a vault (identical to MakerDAO’s CDPs) and sell the tokens on the open market and collect premiums. It is important to note that if an option writer decides to mint oTokens and sell them, they may be subject to losing a portion or close to all of their collateral if the contract is exercised by the buyer (depending on how deep the contract is in-the-money).
On the flip side, anyone can purchase oTokens and use the contracts for a plethora of different investment and trading strategies including hedging, leveraged exposure to the underlying asset, insurance coverage and a few others that we’ll outlined below.
Ultimately, oTokens and the Convexity Protocol allow DeFi users the potential to earn significant premiums on their Ethereum-based holdings by collateralizing ETH or any other asset for oTokens. In addition, oToken buyers can access a much wider range of sophisticated trading strategies that exist in traditional financial markets.
Highlighted Use Cases
Financial Insurance through Protective Put
One of the more prominent use cases in traditional finance is the ability to buy put options to limit downside risk on their holdings. As an example, let’s assume someone bought ETH at $200 and want to cap their potential losses at $50. With this, participants can purchase a put option on ETH with a strike price at $150 which gives them the ability to sell ETH at $150 in the case that the price of ETH ever drops below the said price.
Compound Deposit Insurance
One of the bigger applications to have emerged in 2019 has been lending markets. Compound Finance allows users to deposit crypto assets and earn interest on their deposits. More specifically, when depositing capital on Compound, users receive cTokens in return which gives the owner the right to claim their deposits plus interest at any point. If for any reason Compound experiences a black swan event (like a hack, flash crash in price, liquidity crisis, etc.) and cTokens are no longer redeemable, users can purchase a put option that gives the buyer the right to sell their cTokens at a predefined rate to the seller.
Dai Price Hedge
By using put options, DeFi users can hedge against any significant drops in Dai’s price peg. By holding oTokens, participants can have the right to exchange 1 DAI for 0.99 USDC. If Dai’s peg drops significantly to 0.50 USDC, the oToken holder is protected as they maintain the right to exchange 1 DAI for 0.99 USDC despite the fact that exchange markets are trading for well below that price.
This is a rather high-level overview of how Convexity Protocol establishes a generalized framework for options on Ethereum. While the majority of the use cases and examples outlined in this post use put options, the framework easily allows users to create options contracts for either side of the trade.
While Convexity may not become the de-facto standard for tokenized options contracts as it’s early in its development, it is important to understand the possibilities when the ecosystem finally introduces a robust protocol for options contracts. Given traditional markets, establishing this framework will allow DeFi to mature by creating access to more sophisticated trading strategies.
Ultimately, it will be interesting to see the implementation of oTokens and how they operate in the open market and how it will affect the dynamics of DeFi, Ethereum, and crypto-assets at large.
Analyst at Bankless – one of the leading resources for open finance. Lucas is an active contributor to the DeFi ecosystem with appearances in other notable DeFi outlets including The Defiant and Our Network. He has years of experience working with dozens blockchain and token startups where he focused on token economics, marketing, and growth.