Please describe your proposed solution.
Options on Cardano
Implementing options on the Cardano blockchain involves a unique approach that leverages the strengths of the blockchain's architecture. The system is designed around two key components: a minting policy and a validator.
With this approach, an option is simply a Cardano native token, and as such, it can be traded freely like any other token. This opens up a whole new level of flexibility and accessibility for options trading on the Cardano network.
The option smart contract protects both the option holders and the option writer. For the holders, it is guaranteed that they will be able to execute the option during the execution interval, taking "deposit" tokens in exchange for the right number of "payment" tokens. For the writer, it is guaranteed that they will get their deposit back - either in the form of deposit tokens that haven't been claimed or in the form of an equivalent amount of payment tokens. This dual protection mechanism ensures fairness and security for all parties involved.
In addition, option smart contracts eliminate the centralized intermediary restrictions and risk. Option buyers and sellers don’t face any limitations in the amount or type of options they can utilize by a clearing house. In addition, market participants do not have to worry about the solvency of the intermediary.
When someone wants to issue (“write”) an option, they specify a token pair: one is the "deposit" token, and the other is the "payment" token. The issuer locks a number of deposit tokens in a smart contract, which is secured by the option validator. They then mint the same number of options as Cardano native tokens, with these options governed by the option minting policy.
The minting policy of the option token ensures that the correct number of deposit tokens has been locked in the option smart contract. This is a crucial feature that guarantees the integrity of the system and ensures that the options can be executed, eliminating the need for a traditional clearing house.
The validator guarantees that during a specified execution interval, any holder of an option token can exchange it for one deposit token, provided they burn the option token. This exchange requires the holder to also deposit a specified number of payment tokens.
For example, consider an option that is parameterized by the two tokens ADA (Cardano's native cryptocurrency) and ACME (the Acme Inc. utility token). In this case, ADA could be the deposit token, the price could be set to 1.5 ACME per ADA, and the execution interval could be set to a specific period in July 2023. This setup realizes a "put" option. During this interval, a holder of 750 option tokens could burn those tokens, take 750 ADA from the deposit, and deposit 1,125 ACME tokens (1.5 * 750).
To realize a "call" option, we can simply swap the roles of the deposit and payment tokens and use the reciprocal of the price. For instance, ACME could be the deposit token, the price could be set to 0.67 ADA per ACME, and the execution interval could be the same. During the execution interval, a holder of 750 option tokens could burn those tokens, take 750 ACME from the deposit, and deposit 502.5 ADA tokens (0.67 * 750).
This system covers both "put" and "call" options, as well as both American and European options, as the execution interval can be set to any arbitrary time interval. Finally, the number of issued options is completely flexible and depends on the number of deposited tokens.
Many option protocols on Ethereum or Ethereum Virtual Machine (EVM) compatible blockchains utilize an account model that pools users’ assets, forcing option liquidity providers to share trade fees and risks such as impermanent loss. Sharing risk and return limits the ability for option liquidity providers to manage the risk of their positions and can lead to catastrophic losses in times of high market volatility or quickly shifting market sentiment.
Options on Cardano correct the weaknesses of option protocols that pool users assets together through Cardano’s novel EUTxO model, which allows every option to be separate, unaffected by the outcome of other options. Instead of sharing potential profits and losses among many unknown market participants, each option liquidity provider is able to create option positions whose profit/loss output is unique to the terms of that specific option. In contrast to sharing unpredictable return and risk, option liquidity providers have full control of the return and risk profile of each option they create, including the amount of liquidity, the assets, the execution price, and the term of each option.
Technical Implementation
Our implementation of options on Cardano consists of two smart contracts working in tandem, the option minting policy and the option validator.
Parameters
Both smart contracts are parameterized by:
- The “deposit” token.
- The “payment” token.
- The execution interval.
- The price.
The Option Minting Policy
The minting policy for the option token guarantees that for each minted option token, a “deposit” token is locked in the option smart contract.
The Option Validator
When minting option tokens, the same number of “deposit” tokens is locked in the option smart contract. This contract guarantees that deposit tokens can only be removed during the execution interval if the correct (determined by the exercise price) number of “payment” tokens is put in and if the same number of option tokens is burnt.
It also allows the option writer to remove all remaining “deposit” and “payment” tokens, once the execution interval has passed.
Future Improvements
Looking ahead, there are several areas where the system could be improved. One possibility is to allow the staking of deposited ADA. For example, a trader selling an option where they deposit ADA that is temporarily locked for the term of the option could accumulate “locked” ADA staking rewards. Depending on whether the option is exercised, the accumulated staking rewards provide an extra source of profit for the option seller or the option buyer. In the Cardano network, addresses are pairs consisting of a payment part and an optional staking part. The payment part of the deposit address is the option validator, but the staking part could be the option writer’s staking key. This means that if the option writer deposits ADA in the smart contract, they could earn staking rewards during the duration of the smart contract. This would provide an additional incentive for investors to participate in the options market.
Another potential improvement is the development of a dashboard that provides a user-friendly interface for managing options. This would make it easier for investors to track their options, execute trades, and monitor the performance of the market. A well-designed dashboard could also provide insights into market trends and help investors make more informed decisions.
Prototype
We have developed a prototype UI, which allows users to mint options for arbitrary token pairs, execution intervals, and prices. If desired, these options can be executed during the execution interval. This prototype represents a significant step towards making options trading more accessible and efficient on the Cardano network.
Conclusion
In conclusion, the introduction of options on the Cardano network represents a significant advancement in the field of decentralized finance. By leveraging the unique capabilities of the Cardano blockchain, we can provide a more flexible, efficient, and transparent options market. The fact that an option is simply a Cardano native token that can be freely traded, combined with the dual protection mechanism of the option smart contract, makes this system uniquely advantageous. This will not only benefit individual investors but also contribute to the overall stability and maturity of the crypto market. As we continue to refine and improve this system, we look forward to seeing the innovative strategies and opportunities that it will enable.
How does your proposed solution address the challenge and what benefits will this bring to the Cardano ecosystem?
The challenge question is: "What products and integrations can be developed or improved that will offer more use cases to the Cardano ecosystem that are high impact and drive more adoption?"
Our approach is to bring a widely utilized traditional finance (TradFi) instrument and make it available on Cardano. And not just available but better. This caters to the needs of current Cardano DeFi users and lures in newcomers from TradFi.
Options in Traditional Finance
In traditional finance, the two main types of options are call and put options. In every option, there are two parties, the option buyer and option writer. Options differ from other derivatives, such as futures, in that option buyers have the right, but not the obligation, to exercise the option before expiration.
A call option gives the buyer of the option the ability to buy a certain amount of an underlying asset at an exercise price, or strike price, by the expiration date of the contract. If the option is exercised, the option writer, or seller, must deliver the asset or cash value of the asset at the exercise price.
The buyer of a call option is usually “bullish” on the underlying asset, meaning that the call buyer believes the market price of the asset will increase. If the asset’s market price increases above the exercise price before expiration, the call option buyer could profit by first exercising the option to buy the asset at the strike price and then subsequently sell it on an exchange at the higher market price.
A put option gives the buyer of the option the ability to sell a certain amount of an underlying asset at a specific price by the expiration date of the contract. If the put option is exercised, the option writer must buy the asset or cash value of the asset at the strike price.
The buyer of a put option is usually “bearish” on the underlying asset, meaning that the put buyer believes the market price of the asset will decrease. If the asset’s market price decreases below the exercise price, the put option buyer could profit by exercising the option to sell the asset at the strike price after buying it on an exchange at the lower market price.
On the opposite side of each option are the option writers, or sellers. Call and put option writers create the options contract. If a trader creates and sells a call option, the trader is considered bearish on the asset’s price. Alternatively, the writer of a put option is considered bullish on the asset’s price. The option writer determines the terms of the contract before creating the option and offering it for sale to potential buyers on an exchange.
American vs European Options
Options are also classified as American or European based on the timing of their execution. American options can be executed at any time before the expiration date, providing flexibility for the holder. European options, on the other hand, can only be executed on the expiration date, which requires careful timing and strategy.
Single Point of Failure
In traditional finance, the execution of options is guaranteed through the use of clearing houses. A clearing house acts as an intermediary between the buyer and seller of an option. When an option is bought or sold, the clearing house takes on the obligation of the opposite party. This means that if you buy an option, the clearing house guarantees that you will be able to exercise it if you wish to do so. The clearing house ensures this by requiring the seller of the option to provide collateral, usually in the form of cash or securities. This collateral is used to fulfill the seller's obligation if they are unable to do so themselves. The clearing house could also restrict derivative use on its platform to keep their notional value exposure within a desired range or restrict certain types of options.
A weakness for derivatives in traditional finance is the centralized intermediary between option traders. Since the intermediary is financially obligated to settle all options, each option is an asset or liability on the intermediary’s balance sheet. The single point of failure is the intermediary. If a party in the options contract does not have enough collateral to settle the transaction, the clearing house is obligated to settle the transaction. If the clearing house cannot settle the transaction, an option buyer risks non-receipt of the asset or funds.
Any restrictions and collateral requirements from an centralized intermediary place an additional financial burden on some investors. These restrictions also limit investors’ ability to utilize options, reducing the liquidity and transparency of the markets.
Number of Issued Options
The number of issued options is another important aspect, as it indicates the liquidity and depth of the options market. In traditional finance, options are typically issued in certain fixed, common numbers. For example, you might find options contracts for 100 or 1,000 shares, but it would be highly unusual to encounter a contract for a non-standard number like 139,465 shares. This standardization helps to streamline the market and make pricing more transparent. It also facilitates trading and increases the overall liquidity of the market.
Learning from TradFi and making options better
We will take into account the above considerations and aim to create a financial instrument that is easier to use, more flexible and widely available. This way we address the challenge brief that states "Cardano needs a thriving ecosystem of different products and integrations for the community to use that increasingly become the better alternatives over current centralised providers". We are committed to do just that.
How do you intend to measure the success of your project?
Benefits to investors and measuring them
Options are a cornerstone of traditional finance, providing a level of security and flexibility that is essential for the healthy operation of markets. The multi-trillion dollar options market allows investors to:
- Hedge against potential losses
- Leverage trade to increase the upside of an investment with a small amount of capital
- Speculate on future market or price movements of an underlying asset or index
- Generate income by selling options to collect premiums or trading derivatives on a relative-value basis
- Gain exposure to assets when owning the underlying asset, such as commodities, is not feasible
Options can provide a mechanism for managing the inherent volatility of cryptocurrencies, thus contributing to the stability and maturity of the market. The introduction of options on a DEX, therefore, represents a significant advancement in the field of decentralized finance, opening up new possibilities for risk management and strategic investment.
We can measure the success of the project by surveying and interviewing our investor users, asking them directly whether the now available options are giving them the above mentioned benefits.
Please describe your plans to share the outputs and results of your project?
The options protocol is a DeFi, permission-less protocol accessible to anyone. Genius Yield has built a community of over 23,000 followers on Twitter, over 6,700 Discord members, and partnerships with other entities that could market the options protocol.
Our protocol will give millions of Cardano users around the world, many of whom don't have access to derivatives in traditional finance in their home countries, the ability to hedge, leverage trade, generate income, and speculate on assets previously not possible.
We believe our options protocol is a key pillar in our mission to democratize finance for all by providing the permission-less opportunity to use options, a derivative whose use has historically been limited to residents of who live in countries with a developed financial system.