Risk Is Everywhere — A Comparison of DeFi Risk Management Tools
In this article, we discover 7 different DeFi products that offer some form of downside protection, delta-neutral strategy, or risk-on (and risk-off) yield.
Risk is everywhere. It feels like the world is imploding. The BoE stepped in with a $72.3 billion stimulus package to prevent England from a 2008 style market meltdown. There is US inflation over 8% with the FED signalling interest rate rises until something breaks. Throw in the Russian/Ukraine conflict which is as much a commodity crisis as it is a humanitarian crisis. Clearly, there are serious headwinds to overcome.
The correlation with decentralised finance and the macro markets cannot be understated. In a risk-off macro environment, risk assets such as cryptocurrency also suffer due to the liquidity crunch. However, this correlation can have a positive edge as risk management tools from Tradfi can be adapted, enhanced, and deployed with transparency on DeFi rails.
Risk Management and Portfolio Protection
There are many options available to manage risk whether it be an option (pardon the pun) or another derivative product such as the perpetual swap. Although somewhat sophisticated, these decentralised finance products are packaging together the tools that Tradfi use to hedge risk and to generate yield even in times of uncertainty and/or sideways/bear markets.
The main question is:
Will the proponents of web3 learn from the mistakes of the money markets in Tradfi and provide a level of transparency and security through blockchain systems,
or,
Will the efficiency and accuracy of an immutable codified market cause the mistakes to be repeated over again but on an accelerated level.
In either case, these products here under review are generally suited to those who seek to preserve capital or, are prepared to be brave and seek risk-adjusted returns.
The Selection Criteria
In traditional finance, these tools are seldom accessible to retail investors, and so, it is hedge fund managers and quant traders using these tactics.
Decentralised finance has made these tools openly accessible to anyone which has now spawned an age of yield farmers and mercenary capital — people who engage with a protocol for short term incentive programs.
This cohort of users will happily jump through hoops whereas retail and other institutional cohorts will not. Why?
For the most part, the DeFi user experience in its current state is less than ideal. The goal should be to reduce complicated steps and avoid the need for instruction and documentation just to use a particular product.
Therefore, the selection criteria not only assesses the financial mechanism features, but also the simplicity of the design — the user experience!
The non-exhaustive list:
- https://toros.finance/
- https://www.rysk.finance/
- https://www.ribbon.finance/
- https://www.arrakis.finance/
- https://mycelium.xyz/
- https://www.brahma.fi/
- https://fuerte.fi/
- https://www.lyra.finance/
Note: These assessments are observations and not recommendations. Leading the assessment with the value proposition should help the reader get a high level overview of the protocol objective.
1. Toros Finance
Value Proposition: Toros enables a suite of one-click financial tools which simplify complex strategies
Toros Finance is an incubator protocol on Polygon that provides 1-click access to dynamic vaults. A dynamic vault is an algorithmic investment strategy that targets a specific payoff. The investment strategy can change for improved returns, but the underlying market risk remains constant.
For example, the USD Market Neutral Yield earns yield on crypto assets while simultaneously being market neutral (hedged), which results in earning yield on USD while uninfluenced by crypto price volatility.
To deploy this type of market neutral strategy manually would require active management and multiple transactions quite possibly across multiple platforms/dapps.
The ability to access market neutral yield in 1-click is as simple as it gets.
TEAM: https://www.dhedge.org/
BACKED BY (Indirectly): Synthetix, Framework, DACM
PRODUCT READY: Yes
CHAIN: Polygon and Optimism
AUDITED: YES — Via DHedge (Audit here)
TVL/AUM: $ 6.4M (according to DeFi Lama)
READING/MEDIA:
2. Rysk finance
Value Proposition: Earn uncorrelated yield whilst targeting market neutrality
Value Proposition: Rysk provides products that will produce an uncorrelated, competitive yield in all market conditions, unlike most token-emission-based yield farms.
The Rysk Dynamic Hedging Vault (Alpha) solves a very specific and common problem. By using this product (depositing into Rysk Dynamic Hedging Vault) you are uncorrelated to the movements of the crypto market. Correlation has been a problem with the majority of crypto projects whose market value is dragged along with the fluctuations of the majors — BTC and ETH. In lieu of recent events, one only needs to look at their ALT portfolio amidst the LUNA debacle to see that the sharp sell-off in BTC punished portfolios across the board.
Unless of course, you were delta-neutral, a trading strategy used by advanced asset managers and hedge funds (hence the term being “hedged”).
Typically, fund managers are hedging risk by simultaneously buying and shorting assets in a long-short equity strategy. Until very recently, this has been somewhat out of reach for retail and/or requires active management.
Rysk automates this process by algorithmically targeting Delta zero or close to zero. They call this a Dynamic Hedging Vault (DHV)
Upon inspection, the user only needs to deposit their asset (USDC) into a pool and in return, receives a token that represents the share owned in the Dynamic Hedging Vault
(essentially an LP token).
The protocol then takes that liquidity and generates market-neutral yield for its liquidity providers (user/depositors) by writing (selling) Put and Call options. On the other side of the Dynamic Hedging Vault (position), the buyer could be other active managers, an exchange hedging their own exposure or other structured products that require options strategies. However, that is not of concern to the user/depositor as the Rysk Option AMM uses an incentivization model, where options are priced cheaper or more expensive, based on a function of the Black Scholes formula, the pool‘s delta exposure and its utilization.
What’s more interesting is Rysk claims the ability to interact with any derivative with a trackable delta. This means other derivative products that are on-chain, and have the ability to output an index price feed, could be composable with Rysk. (More on this later!)
Protocols will integrate with Rysk for many reasons. For example, using Rysk vaults for yield as a service, accessing hedging instruments for treasuries, creating spreads or structured products, developing derivatives on top of Rysk or integrating with any of the Rysk vaults for options exposure.
TEAM: @Jib0xD @Josh_0x01 @RyskyGeronimo @ugolino_me
BACKED BY: TBA
PRODUCT READY: The DHV is in alpha (as of 28th Oct).
CHAIN: Arbitrum
AUDITED: Dedaub, Akira, and Peckshield audits coming soon.
TVL/AUM: NA
READING/MEDIA:
- https://medium.com/@rysk-finance/rysk-alpha-club-want-in-d36fa5ddb49e
- https://medium.com/@rysk-finance/rysk-is-the-only-free-lunch-e4f832af0026
- https://docs.rysk.finance/architecture/dynamic-hedging-vault-amm
3. Ribbon Finance
Value Proposition: Earn sustainable yield through decentralised options vaults.
Ribbon Finance is the first crypto structured products protocol on Ethereum. They have taken a complex topic (crypto Options) and abstracted away the selection of strike price and expiry (and the greeks) to offer up a simple 2-choice selection for amplified yield. This is great from a user experience perspective. The UI distills a multistep process down to a few clicks. While it certainly has some attractive APY, it is hard to call anything “risk-free yield” as the two mechanisms of choice in this product (covered calls and selling naked puts) still come with inherent risk.
Some notes on selling Options in DeFi…
Synthetic Mining is a loose term given to the strategy of selling close to expiry OTM options in crypto. To put it simply, the price of an option declines at an accelerated pace in its last 28 days, this phenomenon is called Time Decay (AKA Theta Decay).
The faster the time decay, the more wriggle room the option seller will have if the underlying price begins to move closer to the strike sold. If the contract expires OTM, the option seller keeps the premium. This can be repeated every 28 days, or every week, simulating an effect of BTC or ETH mining — hence Synthetic Mining.
Do this at your own peril! One can have 6 straight months of successful “synthetic mining” in a bull market only to have all the returns (and more) wiped out in a single liquidation event (i.e., December 5th). Basically, selling options means you short gamma and in a gamma squeeze you do not want to be short! (Remember Gamestop?).
Ribbon’s Theta Vault puts this strategy on autopilot. The smart contract runs an automated options selling strategy, and if the options expire worthless the vault keeps the premium, which is the APY the user receives each week.
For this reason, it is not risk-free yield as there is a possibility that volatility in the underlying asset moves the Out-Of-The-Money options contract to In-The-Money. (Yield gooooone!)
That being said, it looks like Ribbon V2 is expanding beyond these two options strategies starting with the Meta Vault which combines the two vaults in what’s traditionally called a Short Strangle. Without getting too deep into the weeds, the Strangle is one of many options spread strategies that looks to become part of Ribbons’ structured product offering.
TEAM: Julian Koh, Ken Chan
BACKED BY: Paradigm, Coinbase Ventures, Nascent, + more
PRODUCT READY: V1 Yes, V2 Yes, V3 TBC
CHAIN: Mainnet Ethereum
AUDITED: Yes — Here
TVL/AUM: $167.2m
READING/MEDIA:
4. Arrakis
Value Proposition: A community-owned protocol that offers secure, automated liquidity management.
Arrakis was spawned from Gelato — an automation tool for smart contracts. Arrakis is a liquidity layer built on top of Uniswap V3. Whilst the use cases are more suited to market makers and liquidity providers, it provides the ability to automate delta-neutral strategies which makes it worth mentioning for the purposes of this article. Ultimately, Arrakis products will reduce the barriers for retail users to participate in Liquidity Provision.
With Arrakis vaults, passively holding an ERC20 LP token automatically exposes an LP to the underlying automated strategy…
Moreover, Arrakis opens the door for a new area of decentralized market making with the potential for tokenized products like:
- Liquidity as a Service Strategies
- Auto-Hedged delta-neutral LP positions
- Sophisticated multi-positions on concentrated AMMs
- Cross-AMM positions
- LP positions coupled with lending/borrowing or options markets
- Cross-chain strategies
“Arrakis is currently deployed on Ethereum, Polygon and Optimism. Since Arrakis is currently a composable layer on top of Uniswap V3 it can be on any network where UniV3 is up and running”.
TEAM: @hilmarxo, @RitualTypist
BACKED BY: Does not list “backing” per-se but lists other protocols using their liquidity management (such as Maker, Frax, Rari)
PRODUCT READY: Yes
CHAIN: Ethereum, Polygon and Optimism
AUDITED: YES
TVL/AUM: $ 708M
READING/MEDIA:
5. Mycelium
Value Proposition: Trade with liquidity, leverage and low fees. More Leverage. Less Overhead
Previously Tracer DAO, Mycelium is a protocol/platform with a whole array of derivative products that plan to become the web3 financial plumbing, rather than just a neat way to trade crypto assets. Nonetheless, let’s break down the products that are on the market right now and see how it can be used to mitigate risk.
Perpetual Pools as the name suggests is a perpetual-like product that behaves somewhat like a Perpetual Swap, but with a unique mechanism that does not require maintenance margin and also is void of any liquidation risk. How the mechanism works is a little complex (see here) but the result is the ability to hedge a portfolio (being delta neutral) by taking out a position in a variety of pools, without worrying that your position will get liquidated. Here’s an example.
Scenario: A trader holds spot ETH. The market looks weak.
Without Perpetual Pools: Trader seeks to hedge their portfolio and opens a short Perpetual Swap on a CEX. The trader must add more collateral to the CEX to cover the maintenance margin for the short position. The trader is now delta-neutral. The market rallies overnight. The short position gets liquidated automatically as the maintenance margin the trader puts up falls below the CEX’s risk engine parameters. The trader loses capital deposited on the CEX but makes money on the long ETH position.
With Perpetual Pools: Trader seeks to hedge their portfolio and opens a short Perpetual Pool. The trader deposits USDC into the 3x ETH/USD pool (to the value of ⅓ of the spot position). The trader is now close to delta-neutral. The market rallies overnight. The short position DOES NOT get liquidated. There may be an unrealized loss, however, the trader can remain in the pool indefinitely. The pool tokens can be burned to redeem USDC when A) The index price of ETH is in a more favorable position or B) the rebalancing mechanism causes a skew where there could more profit in burning the pool tokens on the losing side of the pool (for a short period of time until the next rebalancing event).
The example above is only one use case (hedging). Of course, if a trader was momentum trading and wanted to take directional leverage bets, then entering any 3x pool would provide this leverage exposure without the fear of getting being liquidated.
TEAM: @pat_mcnab, @ray_mogg
BACKED BY: Framework, DACM, Koji, Mavin11, and more
PRODUCT READY: Yes
CHAIN: Arbitrum
AUDITED: Yes 5X (as reported here)
TVL/AUM: $20M (according to Defi Lama)
READING/MEDIA:
6. Bramha
Value Prop: (OLD) Brahma is a protocol providing a seamless interface for DeFi users to access sustainable, risk-managed strategies. (NEW) Earn, hedge, and deploy capital across DeFi with Brahma.
Brahma is a non-custodial protocol that activates and manages liquidity across chains and dApps.
Brahma Vaults: First set of products launched by Brahma, which gives permissionless access to institutional-grade risk-managed, cross-chain strategies for sustainable yield!
Quantitative strategies are developed by independent strategists to the protocol, both core contributors and strategists creating a “structured product” of sorts.
Degen Vaults: Experimental products that are unaudited but have been through rigorous self-audit by the team. These are limited to certain users in DeFi based on their Karma Score.
DegenVaults are strategies which are tailored for and made accessible only to experienced DeFi users
Karma: On-chain and off-chain scoring mechanism for the Brahma community (and the world) that can be claimed at any point from here → karma.brahma.fi
KARMA points mirror your community contribution. It is earned by performing authentic on-chain and off-chain activities. Karma cannot be bought, only earned.
This is quite unique and reinforces Metcalfe’s law which has been a driver for many successful networks both in Web2 & Web3. In addition to this, the assumption is that this mechanism of contribution points should deter any mercenary capital and keeps the focus purely on contribution and growth activities.
Also, you need Karma to access new (risky) products.
Compound KARMA points to bag exclusive access to upcoming vaults, unique product features and more.
Should a user accept the risks, and, contribute to the community, the product makes a lot of sense. Brahma takes the interest earned in L1 yield farming pools (i.e. Convex or Curve) and then bridges this capital to Optimism via an aggregator once a week for GAS efficiency, then, the capital is then used to make leveraged bets in the form of a long ATM options contract, and, if the bet is right, the payout is pretty good and thus the pool receives a decent return. Again, once a week for efficiencies. Here’s how they do it:
- Single-side deposits are accepted in ETH
- The vault supplies this ETH to the highest yielding Curve pool and LP tokens are staked on Convex
- Which pool? stETH/ETH — more details below
- At the end of every week, all accrued yield is harvested and converted to ETH
- The yield is bridged to Optimism and used to take a leveraged bet on crypto prices
- What leveraged bets are used? 1 week ATM options are purchased on Lyra Finance — more details in the coming sections
- Any trading profits at the end of the week are converted back to ETH, bridged back to mainnet and compounded into the strategy
What is interesting about this strategy is that the ATM Long Option is the most expensive option to select. Why? Because Delta is the highest ATM. So, unlike some of the other protocols that are selling options (selling premium), Brahma is buying the most expensive option with the highest delta, which, ATM options have a 50/50 chance of paying off (by the very nature of being at the pinnacle of the bell curve).
The only downside of purchasing options is the option expiring worthless. From Brahma’s perspective, it’s an easy bet, the capital used to purchase options (not write) is the interest earned on depositors’ collateral (free money), therefore, if the option expires worthless, no capital additional capital (users capital) is at risk. If the option expires ITM, it’s payday! Reading through a publication from Brahma, it appears they confirm this and through backtesting, have ascertained that this is the best strategy out of 8 simulations tested.
When using the momentum signal, similar performance is seen for both strategies with the base APR improved by 1.25x. Importantly, the option buying strategy is much less operationally intensive as it does not need to be monitored for take profit and stop loss conditions. This is because a long option position cannot be liquidated, unlike a leveraged perp position whose returns will always be path-dependent due to that liquidation risk.
However risk-free this might sound, there is always smart contract risk and one should tread with care. Perhaps there is a bridging risk with socket and/or who governs the pool (which is openly stated here).
“Unlike most protocols out there, we don’t market on predicted APY but the actual APY% since inception, updated per block”
Transparency is key, displaying real APY via real returns over aggregated APY from native token yield farming incentives shows that the real product potential.
TEAM: @0xdanzu, @BapireddyK, @thesoberguy13, @jainargh, @daestair_
BACKED BY: Framework, Mavel11, Ledger Prime, The LAO, and others.
PRODUCT READY: Yes
CHAIN: Mainnet Ethereum (User) L2 Optimism (Perp Position Holder)
AUDITED: Yes — See here
TVL/AUM: $2.1M (according to DeFi Lama)
READING/MEDIA:
7. Fuerte
Value Prop: One-stop shop for the best DeFi strategies
Fuerte appears to be quite early stage, and without a product ready for immediate risk management. However, if the product experience as easy to digest as the description of the 3 strategies listed, they will have a pretty good chance of onboarding users.
If a user is somewhat familiar with derivative strategies, even the simple ones, these three “flagship” products should make sense immediately without needing to dive too deep into documentation. Essentially, the 3 choices are.
- A Delta Neutral Vault — Yield is captured through selling volatility using Squeeth
- The Cash and Carry Trade — Capturing yield from futures spreads.
- Options Vaults (coming soon) — States both shorting volatility (I assume this will be short puts or short some sort of spread) as well as principle protection (which could very well mean a married put scenario).
Ok, so these might not sound so simple after all so let’s break it down just a little. We will start with the Cash and Carry trade as the learning here will carry over into the squeeth vault.
- Cash & Carry vault — The vault manages a delta-neutral long spot / short perpetual swap ETH position. Yield is generated by collecting funding fees.
Simply put, this position buys ETH and at the very same time sells an ETH Perpetual Swap. Because there is a long position and a short position, the spread is Delta Neutral meaning that one side will make money as the other side loses money. How is yield generated in this case? Derivative products such as Perpetual Swaps have a funding rate where a small percentage is paid to the seller of the derivative contract. Traders can “farm” this funding rate by having a delta-neutral strategy, or, you can use one of these Fuerte vaults, which automates the strategy for you with compounding effects (future updates will balance between assets with the highest funding rate)
2. Dynamically-hedged Squeeth vault — The vault manages a long ETH / short Squeeth position that targets delta neutrality. Yield is generated by shorting realized volatility and capturing market inefficiencies.
(TLDR Squeeth is “Squared ETH” a derivative product similar to a perpetual swap but instead of tracking the price of ETH it tracks the price of ETH2).
This strategy farms the difference between implied volatility (a metric to measure future fluctuations in price) and realized volatility (the realized price of the derivative) by shorting squeeth and hedging with ETH. Confused? Let’s break it down:
Short Squeeth is akin to a short straddle. In TradFi, a straddle is an options spread that comprises a Put and a Call, usually ahead of an earnings call where the market may move in any direction. Of course, ahead of earnings, implied volatility will be high as the market EXPECTS a big move, after the earnings event, the REALIZED volatility (when the options expire) is ideally less, therefore as a straddle seller, the trader collects premium when IV is high (expensive options), and closes the trade when IV is low (cheap/worthless options).
Therefore, a short squeeth will have negative delta when ETH rises and positive delta when ETH collapses. Manually, what this strategy looks like is holding spot ETH and at the same time going to https://squeeth.opyn.co/ depositing ETH and minting a short Squeeth position. Then, monitoring the delta and readjusting either leg as required to keep the delta near zero. Again, it’s much simpler using the Fuerte vault which automates this strategy for the DeFi user.
3. Options vaults — Short volatility and principal protection vaults are coming soon.
In Defi, there are many yield generating products, however, a principle protection product certainly would be an interesting primitive. Upon probing, the first of these products would be a covered strangle with some form of capital protection.
It would be interesting to see some backtesting here, Fidelity states “Choosing the covered strangle strategy based on a modestly bullish forecast requires both a high tolerance for risk and trading discipline. High tolerance for risk is required because risk is leveraged on the downside”.
TEAM: https://twitter.com/0x_yan,
BACKED BY: TBA
PRODUCT READY: Release date TBD
CHAIN: Mainnet Etherium/Optimism
AUDITED: TBD
TVL/AUM: NA
READING/MEDIA:
- https://twitter.com/FuerteFi/status/1527306033135513601
- https://twitter.com/crypto_noodles/status/1519316801045282817
8. Lyra
Value Proposition: Lyra’s decentralized exchange is the easiest place to buy and sell options on cryptocurrencies.
Last but not least, there is Lyra.
We’re building a high-performance, peer-to-peer options trading platform. Buy and sell options on your favourite crypto assets with low fees, deep liquidity and accurate pricing, secured by Ethereum.
Many of the above protocols that are building advanced options strategy vaults are doing so on Lyra’s Option stack (if you can call it that). Therefore, there is no need to repeat many of the various options strategies that can be turned into yielding vaults or some form of delta-neutral hedging. Almost all option strategies can be composed, in theory, if there is liquidity. Where most option protocols have fallen short, Lyra has been able to iterate on the v1 product and with the release of the Avalon upgrade it will provide the ability for option buyers and option sellers to go as far out in time as 12 weeks. A huge leap in the option space (not quite a LEAP, but perhaps that will come one day).
Lyra will set a new standard for on-chain options trading with The Avalon Upgrade. Rolling options expiries out to 3-months, unified liquidity across strikes, partially collateralized short options, anytime entry/exit from market maker vaults — Lyra is about to enter a league of its own.
TEAM: Michael Spain, Nick Forster
BACKED BY: Framework, Apollo Capital, Robot Ventures
PRODUCT READY: Yes
CHAIN: Optimism
AUDITED: Yes
TVL/AUM: $14.5M (according to DeFi Lama)
READING/MEDIA:
Portfolio Protection
Is there an appetite for insurance in DeFi? Well yes, the likes of Nexus Mutal and Risk Harbor among others clearly show that the industry and its user have a need for risk mitigation. However, these are examples of insurance for smart contract risk, i.e., bugs and hacks, not downturns in a market or black swan events.
Commonly, whilst in a bull market, no one is looking to purchase puts for portfolio protection. After all, option values decay over time (theta decay), and purchasing insurance in this manner burns through capital.
In some cases, traders are buying calls for the leveraged payoffs. Whilst buying calls in a bull market may sound like an attractive bet, chances are the volatility is high in a bull market, and when volatility is high options pricing is expensive. Evidently, traders buy calls at the wrong time and when the market is violently correcting, seek the protection of Puts (which of course becomes more expensive when IV is high).
Portfolio Protection with Long-Term Deep ITM Puts?
Instead, a trader could factor in buying deep ITM Puts, rolling them month by month, for 5% of the portfolio, this is called the “Married Put” in (retail) Tradfi and is considered a cost of doing business.
As humans in society we pay insurance on our cars and houses, so it would be advantageous to have a protection product such as this for crypto portfolios. However, for this strategy to work, there is a need for long-term options that provide the capability to roll month-by-month and reduce the overall premium paid for the insurance (even <5% p/m). Currently, CEX’s such as Deribit offer 6m+ options. However, liquidity is low and spreads are wide. We still have a long way to go in DeFi but slow and steady wins the race.
In conclusion
Hedging portfolios with delta-neutral strategies are but one way to protect a portfolio, until now, this has required a lot of active management. Thanks to many of the aforementioned protocols, there are many automated strategies that are on the precipice of creating very user-friendly products.
That being said, traditional finance is a complex beast to master, decentralized finance even more so, we must tread carefully, we want to focus on abstracting complexity from the user, but the user must feel safe. Not every financial tool should be available for retail users, but due to the permissionless nature of DeFi, it very well may pan out that way.
Education is key. Security is key. Simplicity is key.
Written By @justdavecx
