Age of crypto structured products
Structured products have always ruled the roost for the conventional clientele of wealth management. Mainly the mighty equity autocallable has long been a favorite among investors as it provides them with upside exposure to specific stocks or baskets along with a cushion of downside protection.
But over the last year, the cryptocurrency sector has been quietly developing its own versions of structured products, which are getting more complex as the months go by. These have predominantly been located in a region of the cryptocurrency landscape known as decentralized finance (DeFi), which is unconnected to any centralized exchange like Binance. As an alternative, the investor uses smart contracts to carry out their investing strategy.
In contrast to most significant, centralized venues, where UK retail users are prohibited from trading cryptocurrency futures due to regulatory reasons, DeFi has no such limitations. A centralized platform may prohibit users from using derivatives depending on the regulatory status of the jurisdiction in which it is located. In other words, users now have access to complex derivatives techniques that would otherwise be out of their price range, for better or worse.
Vaults known as DeFi options held the earliest cryptostructured items (DOVs). Whether it’s stablecoins like tether or USDC, or assets like Ethereum (ETH) or bitcoin, users anonymously deposit crypto into the DOVs, and the DOVs then act as the investors’ agents by carrying out an investing strategy.
The initial DOVs employed basic covered call or put-selling tactics. According to the aggregator website DefiLlama, Ribbon Finance is the first and largest protocol to sell DOVs, with $78 million in its DOVs as of November 4. This is down from a peak of more than $300 million in May, just before the start of the so-called crypto winter. StakeDAO and Thetanuts, two larger protocols that provide comparable products, are also available.
ETH deposits are accepted for the ETH-covered call DOV at Ribbon, which sells one-week out-of-the-money options. The premium, which amounts to about 0.25 to 0.45% per week, is earned by making ETH calls at a 10-delta rate. The premium is forfeited if the options expire in the money, essentially capping the increase in the underlying ETH asset. The underlying risk remains a concern for investors.
The user usually deposits stablecoins into the DOV, which then sells downside puts and earns a premium in the put-selling vaults. Due to the lack of a natural offset in the event that puts expire in the money, these are a little riskier. Market participants can foresee the flow of transactions, though the size and timing of the options selling are well known in advance. According to some researchers, implied volatilities on weekly ETH options are typically four vols lower around the time of the auction than they were 24 hours prior.
Their analysis shows that this translates into premiums that are about 0.1% lower or annual gains that are missed by 5.35%. The market makers who are purchasing the options, on the other hand, claim that they must position themselves for these flows, which some claim account for about 25% of the volatility of the entire supply of crypto options and reach into the billions of dollars notional at some market makers each week.
It was questioned whether the DOVs were the victims of their own success in light of this, and other people questioned whether there was room for growth. For instance, Ribbon considered conducting more sporadic, unscheduled intra-week auctions, but market participants were concerned that they would need more advance notice to handle the traffic. The company Paradigm, for instance, recommends pre-announcement but spaced-out auctions to lessen the impact on implied volatility in its research report.
The businesses, however, have yet to be deterred despite these growing pains and have instead sought to develop newer, more complex techniques.
Ribbon introduced a principal-protected product in August that leverages interest payments to purchase weekly out-of-the-money barrier options at a price of about 8% on the upside and downside. This product makes yield by lending USDC deposits to market-makers like Genesis and Wintermute. It offers a 4% base yield with a maximum reward of 13% depending on whether the options expire in the money.
The next possible step for crypto structured products is currently up for debate. According to insiders, the ultimate goal for companies like Ribbon is to provide the whole gamut of private banking-style goods, including autocallables.
Given the lack of a minimum wealth criterion for investments, some claim they might displace TradFi private banking but with a wider base. However, the assets under the control of companies like Ribbon took a knock after the problems in the cryptocurrency market earlier this year and have since mainly remained constant.
Many institutions have positive positions in this market. A number of them have emerged over the past year to serve institutional clients seeking crypto-structured investments who don’t necessarily want to participate in DeFi themselves or who require custom structuring solutions. These companies, which were created by former derivatives traders at significant sell-side banks, include OrBit Markets and Enhanced Digital Group.
Who knows where it might go if institutional investors regain the enthusiasm they displayed for the market before the onset of the crypto winter?