IVX
Introduction 👋
This is the eleventh article in our Protocol Analysis series. In this series, we use our investment template outlined in How to Analyse a Web3 Protocol to fundamentally and critically analyse a variety of crypto protocols, aiming to separate the ‘real’ from the hype.
As we said in our article on New Order DAO, we’ll be collaborating more with them going forwards, and this article is a first step in that collab! This article was originally published on the Frogs Anonymous website.
Today, we’re taking a bit of a departure from our usual Protocol Analysis template to highlight a newly-launched, very exciting protocol: IVX.
Protocol: IVX, a new options exchange built on Arbitrum that uses AMM-style liquidity pools which serve as the counterparty to all trades on the protocol.
An Introduction to DeFi Options ⌥
The global options market is a gargantuan beast. With a notional value of $500 trillion, it plays a central role in how TradFi hedges its trades - and given that that number is five times the size of the global stock market, it's safe to say it's an important vehicle for leveraging bets as well.
Yet in DeFi, which is purported to be the future of our monetary system, the options market is trivial compared to the spot and futures markets. Options protocols have not garnered enough traction and lag behind other sectors in DeFi.
Why?
First, let’s take a step back and study these protocols, and ask what might be holding them back from reaching their full potential. DeFi options today can be placed into three buckets:
DeFi Option Vaults (DOVs): A structured product made with a combination of options.
Order Book Based Exchanges: An exchange similar to a CEX, where buyers are matched with sellers using an order book of bids and asks.
Option AMMs (Automated Market Makers): A decentralised exchange that pools liquidity in a smart contract, with the price determined by some kind of mathematical formula.
DOVs introduced options to DeFi users in the easiest way possible. They are essentially structured products with a pre-programmed options strategy that users can deposit funds into, each with its own payoff profile. They receive a (real) yield if the vault is profitable. Although this sounds uncomplicated on paper, DOVs have failed to pick up any meaningful traction. This is for three reasons:
Strategies are not financially viable in the long term;
Underperformance of these strategies versus other methods of generating yield;
Misalignment between vault creators, depositors, and market makers.
Order book exchanges have been extremely successful in the TradFi world. Given sufficient liquidity and demand, they function very efficiently. The problem in DeFi is throughput limitations with on-chain order books and high latency. These problems may cause adverse, unforeseen outcomes for traders. Hence, they limit their exposure to these venues. This leads to insufficient liquidity, and consequently, higher fees. This is a vicious cycle and represents the classic cold start problem.
AMMs originated in the spot markets, with Uniswap’s pioneering v2 introducing the constant product model for creating liquidity pools. This allowed users to permissionlessly trade long-tail assets in a self-custodial manner. Options were initially thought to be unsuited to AMMs due to the complexity of pricing them accurately. Without accurate pricing, LPs can be exposed to ‘toxic flow’ from more informed traders. Add to that the risk of impermanent loss, and the problem becomes worse. LPs must therefore charge exorbitant swap fees. This leads to uncompetitive pricing and lack of usage.
So what is needed for AMMs to succeed? They need to be more appealing to LPs, which will require two things - a way to get around the problem of stale pricing and hence toxic flow, and a way to mitigate impermanent loss.
That’s where IVX comes in.
Introducing IVX 💱
IVX is a new Options AMM built on Arbitrum that solves a lot of the above problems with AMMs. Let’s dive into how exactly IVX works, the problems it solves, and how it solves them.
IVX uses AMM-style liquidity pools to create its options protocol. This means that liquidity is pooled into a smart contract and collateralised, then options are written against it to be bought and sold. This pooled liquidity essentially serves as the counterparty to all trades on the protocol.
The IVX protocol has two types of users:
Traders, who are the buyers and sellers of options;
Liquidity Providers, who deposit assets into IVX market making vaults, which are then used to provide the options markets for specific assets. When the traders buy and sell options to or from these vaults, the liquidity providers earn fees.
As we said earlier, however, options AMMs have historically done a bad job of incentivising people to take the risk of LP’ing. So what does IVX do differently?
The Problem with Options LP’ing 💧☢️
First, the problem. An option’s price or its premium is based on two key factors: its intrinsic value and its extrinsic value. Since an option is a derivative, that implies that it derives some of its value from its underlying asset, in this case a crypto asset. This determines the option’s intrinsic value, i.e., basically how “in the money” it is.
Where it gets complicated is the rest of the equation - its extrinsic value. This is determined by a number of variables that are known as “the greeks.” The sensitivity of the option price to the underlying asset’s movements, for example, is known as ‘delta.’ Vega represents implied volatility, Theta represents time decay and time to expiration, and Gamma represents the rate of change of the option’s delta as compared to the underlying assets’ price.
IVX recognises the complexity of pricing options. The added risk comes from options having convex payoff profiles, unlike spot trades which are linear. This convexity increases the tail risk for liquidity providers and one bad day can wipe out months’ worth of gains for an LP. In other words, they tend to make a little profit most of the time, and lose a huge amount some of the time. The biggest form of this risk is delta risk. So how can an options AMM attract more LPs and reduce its costs by controlling for delta risk?
To hedge their delta risk, IVX employs GMX’s perpetuals.
GMX: The Solution to Delta and Vega for LPs 💡
GMX provides an on-chain platform for both perpetual futures and spot trading on Arbitrum. Significantly, all trades on this platform are performed against a multi-asset collateral pool that uses oracles to set prices. As a result, the platform provides zero-slippage trades on both perps and spot.
What this means for IVX is that futures positions can easily be taken out in direct proportion to the LP positions held on its options AMM. As a result, the IVX AMM can dynamically hedge LP positions in a cost-effective and efficient way, entirely on-chain. This strategy is known as a delta-neutral strategy because any deltas accumulated by the options traded on the protocol are hedged away with an inverse position using perpetuals on GMX. This brings the delta down to 0 and gives market makers delta-neutral yield - eliminating the risk of massive losses. So this takes care of Delta.
What about volatility and vega? The volatility surface is a three-dimensional plot showing the implied volatilities of an asset's options that are listed on it across different strike prices and expirations. Not all options on the same asset have the same implied volatility (IV). These differences exist due to discrepancies in how the market prices stock options with different characteristics and what stock option pricing models say the correct prices should be. Markets usually price options using the famous Black-Scholes Model. Of all the variables used in the Black-Scholes model, the only one that is not known with certainty is volatility. At the time of pricing, all of the other variables are clear and known, but volatility must be an estimate.
IVX calibrates an implied volatility (IV) surface according to market pricing and trading on the platform. All trades through the IVX liquidity pool for a given strike and expiry pair adjust this volatility surface and help the AMM calibrate what price to quote for a given option.
In order to ensure that the AMM quotes competitive prices, they are currently investigating incorporating Deribit volatility indices to help reduce deviation from other options venues. This would allow the IVX platform to quote competitive prices to centralised venues in a permissionless way with deep liquidity at all points on the surface.
Hence, IVX has partially solved the problems with AMMs. Toxic flow is solved with more accurate pricing due to the use of Deribit’s volatility indices, which are industry leading at the moment. Impermanent loss has been addressed due to the delta-neutral strategy employed for market makers and preventing any kind of directional bias.
IVX v1 & v2 🚀
IVX v1
In v1, the protocol segments liquidity by the underlying asset. This means that liquidity providers to the platform can choose to provide liquidity to underwrite options on specific assets. The protocol then hedges the positions of liquidity providers using the pool labelled as GLP below. GLP is the liquidity pool associated with GMX, a decentralised spot and perpetual exchange that supports low swap fees and zero price impact trades. The GLP pool consists of assets like BTC and ETH, and traders can use the pool assets to trade perpetual futures.
v1 will also include advanced trading optimisation, which addresses the lack of DeFi protocols that allow liquid option spread strategies in a mutually beneficial manner for liquidity providers. This is enabled by creating 1-click automated strategies to benefit from options spreads across all the pools.
By providing competitive bid-offer spreads, IVX enables traders to execute larger option spread trades with lower transaction fees and associated costs, minimising exposure to potential losses and taking advantage of potential benefits.
IVX v2
In v2, the protocol will unify these segmented liquidity pools into a single AMM pool that underwrites options on all GLP assets and continuously hedges exposures to all assets simultaneously. The benefits of this approach are that the AMM will be able to access deeper liquidity across different levels of volatility simultaneously and will be more capital efficient and competitive with centralised venues like Deribit:
In both versions of the protocol, options positions are hedged automatically for market makers using GLP, GMX’s liquidity pool.
Additionally, IVX is revamping its Automated Market Maker (AMM) to facilitate the integration of GMX's v2 upgrade, which will support synthetic token trading. This move aims to expand trading options and provide greater liquidity for emerging tokens. Some of the benefits of using GMX Synthetics include; access to synthetic ERC-20 and non-ERC20 long-tail assets, improvements in scalability, and a better smart contract system that reduces fees while adding extra layers of security to help reduce the risk of under-collateralisation.
Future Token 🪙
The team hasn’t revealed much about the tokenomics of the protocol. They are still to decide on the distribution and supply schedule. But what they have said is this: All trades on the platform incur a fee which is proportional to the size of the trade and the extent to which the trade will adjust the volatility surface.
These fees are distributed to LP providers and IVX token stakers in accordance with a 70:30 ratio. Hence, 30% of protocol fees will be distributed to IVX stakers on a weekly basis paid out in USDC. As a result, the IVX protocol also pays out a ‘real yield’.
To conclude, IVX is a step up for options AMMs and could become one of the premier decentralised destinations for trading options.
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