Dynamic Hedging Vault (DHV)
Rysk's first product is the Dynamic Hedging Vault (DHV).
Delta is the sensitivity of the value of a derivative (or a portfolio consisting of derivatives) with respect to an underlying asset price movement. A portfolio with a high, positive ETH delta exposure will see its value quickly rise as the price of ETH rises. Inversely, a high, negative ETH delta exposure will result in losses if ETH appreciates but gains if ETH depreciates. A low delta exposure means that a portfolio’s value is not affected much by price movements.
Dynamic (Delta) Hedging is an options strategy that aims to reduce directional risk associated with price movements in the underlying asset. This can be done by buying or selling options, purchasing the underlying asset in spot markets, or using other derivatives such as futures/perpetuals to ensure a delta of 0.
For example, one could purchase a call option with a delta of 0.4 as well a a put option with a delta of -0.4. The sum of the individual deltas (0) is the total delta exposure of this simple portfolio. The portfolio is delta-neutral.
The DHV will act as a permissionless vanilla option AMM, allowing anyone to buy from the vault (or sell to the vault) options at a range of strike prices and expiries. At all times the DHV will be aware of its own position, including its delta exposure, and will price its options in such a way as to incentivise the sale/purchase of options that bring the DHV's delta exposure closer to 0. For example, if demand for calls outstrips that for puts, the vault will automatically increase the price of calls and reduce the price for puts, incentivising a market-driven rebalancing of the book's delta.
During periods of sustained stronger demand in one direction (like our example of more calls sold than puts) and where the rebalancing incentivisation alone isn't enough, the DHV has a number of external tools it can utilise to immediately hedge delta, in either direction. These include, but are not limited to buying spot assets on Uniswap markets, and perpetual futures, offered by Rage Trade.
Liquidity providers deposit funds to the DHV, which are then used to collateralise the options sold by the vault. The DHV collects premiums from traders buying options from the vault and pays out a premium for each option sold to the vault. The corresponding spread between the two forms part of the yield earned by liquidity providers.
In the case where options bought by traders remain on the DHV's books, they are dynamically risk managed through to expiry. Statistically speaking, implied volatility is higher than realised volatility. This means that, on average, the costs of delta hedging an option through to expiry is less than the market-price premium paid. Again, the revenue from this statistical phenomenon passes through to liquidity providers.
Although the DHV targets a delta-neutral book position, being delta neutral does not actually impact the overall yield of a trading book. What it does do, however, is greatly reduce the variability in the daily returns. By virtue of keeping delta-neutral, the DHV's daily revenue stream is kept more consistent, adds protection for liquidity provider's USDC deposit against the price fluctuations of the ETH/USDC market, and means the LP token price becomes largely(*) uncorrelated to the rest of crypto.
(*) [ADVANCED TOPIC] We expect the vault to be short volatility (selling options) most of the time. It is known that the volatility of the price of Ether is negatively correlated to the price movements of Ether itself. Since we are short volatility, this negative correlation becomes a positive correlation for the vault. To combat this, especially at times of high volatility, the DHV will take a slightly negative delta. This has the additional benefit of mitigating gamma. Talk to us in the discord if you want to hear more about this!
In Rysk Alpha, the protocol is designed to verify that users want uncorrelated returns, the models work and the risk management infrastructure is sound. Therefore, instead of a permissionless AMM, the DHV will effectively behave like a desk. It will start by selling a delta-neutral structured product to a counterparty and will then be hedged using all tools that the product has access too, which currently includes perpetuals via Rage trade and spot via Uniswap. In the future we intend to integrate more derivative providers to access more hedging opportunities that might be more cost effective. The next phase, Rysk Beyond will activate fully automated trading described above.
Our liquidity pool prices options according to the Black-Scholes formula using a custom implied volatility (IV) surface. However, the aim is to tilt this value to incentivise behaviours that keep the liquidity pool portfolio’s delta exposure near 0, as well as manage the risks associated with being near full utilisation. It does this through two additional pricing mechanisms:
- 1.Utilisation Premium
- 2.Delta Premium
Once the Black-Scholes price for the option(s) has been calculated, a utilisation premium is added to it, which is a function of the percentage of protocol TVL that has been allocated to collateralise options. This will only have an effect during unusually high utilisation periods.
A delta premium is then applied to the utilisation price. This can be positive or negative according to whether the quoted order will increase or decrease the DHV’s delta exposure. The aim is to give discount to options which move the protocol’s delta exposure towards zero and more richly price options that move its delta away from zero, with increasing magnitude the further from zero the DHV's delta exposure is, up to a limit.
When buying back options the DHV does not use the utilisation skew but still uses the delta skew, so the pool prices the purchase of options that move the delta of the pool closer to zero more expensively (so users are more incentivised to sell back to the pool) and vice versa.
The result of all of this is that under normal conditions the DHV trades at a small spread around standard market prices. In some market conditions however, you may find that Rysk offers a better-than-market price for certain options. The DHV relies on arbitrageurs to capitalise on these opportunities and generate more yield for the vault.
During the Rysk Alpha phase, the options sold will have their price determined by our internal market-derived volatility surface. The next phase, Rysk Beyond will activate the full pricing mechanism described above.
Liquidity providers provide USDC collateral to the vault. This collateral is used to collateralise options which are sold to liquidity takers. Liquidity providers receive yield from the premiums of the options sold. As options are hedged by either selling options or opening other positions which will shift delta to neutrality, the liquidity providers will have an uncorrelated and delta neutral yield. Liquidity providers can either deposit or withdraw from the liquidity pool. Options can be sold with some leverage by using Opyn's partial collateralisation.
Traders purchase options from the vault. Traders can select any strike and expiration, then the vault will price the option (as discussed in #Options-Pricing) and sell the option to the buyer. The trader will then receive a tokenised representation of their option, they can either sell this option back to the pool or they can hold the option to expiration. If the option expires In The Money (ITM) they can redeem their "winnings" from the vault otherwise their option expires worthless and is settled by the dynamic hedging vault. Options sold are European, cash settled and auto-exercising. Traders can be structured products, market makers, DAOs, protocols, institutional investors, options power users and even retail.
Traders will be permissioned until the release of Rysk Beyond.