IIP-34: dVIX - Decentralised Volatility Index

dVIX Proposal

Summary

The decentralized volatility index (dVIX) is analogous to the CBOE VIX index, a popular TradFi measure for measuring investor sentiment. This is often referred to as the “fear index”, or a speculative forecast of the next month’s volatility. This index methodology is proposed by @ampodgorski and @george.

Motivation

The dVIX measures the market’s expectation of 7-day BTC /ETH volatility implicit in the prices of near-term options. dVIX will provide an avenue for traders to trade volatility without needing to consider other factors usually involved in options pricing. As a tool it will provide the option to hedge, speculate, and diversify. It goes up with volatility movement: a sudden upward or downward trend will result in an increase in the dVIX measure. Currently, the CVI and Deribit’s bitVol and ethVol use centralised exchanges as the data to build their volatility measure. With Hegic and Opyn, this can be done in a fully decentralised manner.

The value propositions can be summarised as :

  • Portfolio Hedging
  • Strategic allocation if its to be used as a form of diversification
  • Long/Short Volatility
  • The possibility of volatility arbitrage opportunities

A simple example would be the case where ETH is stable at $1800 after a recent drop from $2100, a trader can take a hedge on his long position by buying the dVIX which will be relatively low from the low volatility associated with sideways price movement. If the price suddenly spikes back up to $2000, they have made money on both their long position and their position in the dVIX. Conversely, the trader will be protected if the ETH price dips further to $1600, as the dVIX will cover some multitude of this loss.

New use cases include the potential to hedge impermanent loss for liquidity providers.

Methodology

Pricing function

The CBOE VIX price reverse engineers the Black-Scholes model with the prices / premiums of options contracts to calculate the “implied” volatility of the market. As volatility is not measurable, even realized volatility is an abstraction. However, implied volatility is a useful measure of investor sentiment as the prices of derivatives in the form of options are often determined by speculative tension between well-informed quantitative strategies. This implied volatility can be obtained by reading the option premium data from a protocol such as Hegic.co. For more detail please see the attached whitepaper.

Calculation Frequency

The calculation will be performed daily.

Data Source and Handling

The data will be sourced from decentralised platforms such as Hegic.

Data Filters

Pricing manipulation prevention will be performed by verifying against other decentralised protocols, and centralised protocols. This will require maintenance and oversight from the methodologist.

Possible Constraints

Main concern is the sparsity of options on Hegic and Opyn. The immaturity of these assets possibly affects the index methodology in that the calculated volatility is very sensitive to new contracts.

Although these platforms are still relatively new the desire here is to grow with these platforms as more decentralised options and maturities are created.

Liquidity Mining

This is a peer-to-contract transaction, and the dVIX therefore requires liquidity to fulfil transactions. Liquidity providers are incentivized by the minting of new dVIX tokens that are backed by transaction fees, but minting occurs with an exponential decay with time to prevent over selling.

Dynamic transaction fees

Moreover, transaction fees are dynamic to allow for minting: similar to Balancer V2, the transaction fee is proportional to the dVIX. Selling when the volatility is high will result in a larger transaction fee to disincentivize over selling. These fees will be shared between the Index Coop, the liquidity pool, and the methodologist.

Entry points

The dVIX itself will be an ERC20 token.

Size of Opportunity

The current crypto market capitalisation of BTC, ETH is approximately 1.3 trillion. With a bigger drive from institutions into the products there will be a greater demand to reduce overall portfolio risk. Given the multiple use cases and incentives of the dVIX, 100MUSD TVL in 6 months is a conservative estimate. There is also the potential of collaborations with platforms such as Hegic and Opyn to use the index methodology to create options around it which could generate more revenue for Index.

Differentiation

The dVIX’s differentiating aspect is that there is not another of its kind at the moment, it is unique from the CBOE VIX in that it can incentivise liquidity providers with liquidity mining, and taking advantage of crypto currency options prices as the asset class approaches maturity. Without sufficient liquidity, it is very difficult to replicate once the first mover has market share.

Author Background

Adam Podgorski and George Lazarides are new Index Coop contributors and founders of 3Sigma Capital LLC. Adam is from a background in nanomaterials for renewable energy and quantitative finance, trying to make a better place one disruptive industry at a time. George is a Chartered Accountant and shares the same vision in trying to change the status quo. We both sit as asset managers at 3Sigma capital with decentralised and centralised portfolios and also getting involved with the treasury and investment committee teams of Index Coop.

Whitepaper can be found in this repo:

12 Likes

VIX products in TradFi are huge and there is nothing like this in DeFi !!

dVIX will create a new market DeFi and will unlock an entire new way for traders to express themselves. Like FLI, dVIX will further extend Index Coop’s moat as the premium index product provider. DeFi needs a VIX product and dVIX is just that.

dVIX can be massive. Hats off to @george & @ampodgorski for coming up with this product. :slight_smile: Simply amazing.

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Thanks @Matthew_Graham! Can’t wait to get it rolling.

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Thank you @Matthew_Graham ! we think it would benefit the crypto ecosystem!

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Welcome @ampodgorski and @george!

You’re landing with a :boom: and I really like the sound of this index product. I think the use cases, target market (huge), and benefits to the Index Coop are logical and compelling. I also think first mover advantage and liquidity are vitally important here. And, the branding advantages of the Coop owning THE Vix product in DeFi are significant.

Given your comments about the early stage development of Hegic and Opyn, what would you suggest an MVP might look like today or soon?

What are the main risks you foresee?

Semi related, as the options infra in DeFi matures and becomes more viable, what do you think of a Variance Risk Premium product in the Coop? (Background: The Variance Risk Premium is Pervasive - and FactorResearch)

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Thanks for the positivity, @DevOnDeFi!

An MVP would still be viable now, but the price would be more stable with more options. Currently, Hegic has certainly has sufficient market depth of options for calls, but perhaps not puts. Therefore, smoothing functions will be required for the MVP of the dVIX currently. This is what Deribit uses in their methodology for DVOL, which is a centralised exchange volatility index of BTC.

By using this query on Hegic’s subgraph ,

query_str = ‘’’{
options(
where: {
status:“ACTIVE”
symbol:"<selected_symbol>"
type: “<option_type>”
}) {
symbol
strike
period
expiration
type
premium
settlementFee
totalFee
}
}
‘’’

where selected_symbol can be either ETH or WBTC, and option_type is CALL or PUT, yields the following.

For ETH Calls (79 contracts):

For

  • ETH Puts: 19 active contracts,
  • WBTC Calls: 13 active contracts
  • WBTC Puts: only 3 active contracts

Therefore, the BTC element of the volatility index might be uninformative if included at this stage. However, the ETH element appears to have sufficient market depth. Given that the equation used in the whitepaper notes that only the term for options expiring in one week should be used, the equation can be tweaked by including weighted terms for results of options contracts with different expiries.

As for your note on a dVRP, yes this absolutely would be a secondary product to the dVIX, but would require more of a liquidity injection due to the risk born by the pool if it were a pool-to-contract protocol. I think that this could also be partly addressed by a dynamic transaction fee model. On first thought it could be an index, if it were a form of weighted index on the dVIX with a leverage ratio like FLI.

4 Likes

Thanks for the informative reply @ampodgorski - awesome.

dVIX and dVRP seem like high value vol related products for the Coop to focus on - and they’re so complimentary, yet polar opposite in nature.

Strongly FOR both.

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Sorry it took a while for me to get around to this but great to see it on the forum! Thanks @ampodgorski and @george for sharing this with us.

Given the level of novelty and differentiation I’m really excited to see the community discussing it, I think it’s an important next step in our product offering. Felix laid it out in his post a while back about branching out from thematic indexes to explore the more complex products that are currently missing in DeFi, dVIX certainly meets that criteria.

When I looked into Hegic before it seemed pretty much unusable unless you were writing options (LPing) as the strike prices were absurd. My level of understanding around options is basic so I’d like to know if that affects what you are looking at, and have you considered how the data will improve as DeFi options improve? Is Hegic just the best place to get the data from right now?

Hi @DarkForestCapital. Thanks for the input.

I agree that Hegic’s pricing function is quite flawed. In fact, I read yesterday on their V1 whitepaper that they calculate it via the implied volatility from skew.com. When you use their subgraph their implied volatility values make no sense. It’s usually a stable value of 9500 for BTC.

That being said, we can obtain the implied volatility from centralised sources. This is achievable and perhaps necessary for an MVP. One main decentralised options protocol whitepaper I’d like to properly look through the next few days is FinNexus. Their OptionsFormulas.sol looks very promising, which can be found here https://www.docs.finnexus.io/options/contracts/.

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Hey @ampodgorski, my understanding is that you need a very deep and liquid secondary options market for a vol index. And that currently, on-chain options pricing is not good. How confident are you that under current conditions the proposed index would actually closely track the volatility of ETH?

Also, I see that you are proposing using 7-day options to construct the index. I assume you will have to roll them forward every week? At what cost? Also, given the potential that these options are mispriced, how would you manage that?

Hi @verto0912

Yes, it needs to be very deep, but I’m not entirely clear on what you mean by liquid. The secondary market for options is certainly in its infancy. Adding a weighted measure from a centralised exchange like Deribit might provide a sanity check on the measure until the options market reaches maturity.

The index does not propose to write options, but only look at the option premiums of existing options or options that could be written according to decentralised options protocols. This has been noted in the above replies. This is a Solidity getter function and would not cost.

In short, agglomerating across several options protocols would provide an appropriate volatility measure, particularly because one can read the options pricing functions according to smart contracts. However, it would be improved greatly and would require less non-TradFi/CeFi maths and metrics once the secondary options market develops on DeFi.

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I just meant you need a wide range of strike prices and maturities for ETH and BTC, with significant secondary market liquidity.

Would it be possible to run a simulation for the next 30 days and see what how dVIX would perform?

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Hi @verto0912, it is correct that you would need a wide range of strike prices. Decentralised option protocols have smart contract pricing functions that are functions of strike price, i.e. pseudo-continuous. These will provide the required market depth to begin with.

It is incorrect that you need a wide range of maturities. You need two: one either side of 7 days from today (or when the calculations are run). If you read the referred DVOL methodology linked above you will see that they use two maturities for their 30 day measure.

In the proposal above, there is a screenshot from a backtest for the month of March using centralised option data, calculated at 30 minute intervals. I have attached a screenshot of a simulation using Hegic on-chain data can be seen here, calculating the 30 day dVIX for ETH 10 days into the future (Figure 1). The bespoke smoothing function for the integral that accounts for the sparsity of options contracts uses, where its peak is a function of the median option premium for the relevant expirations (Figure 2). Comparing this to Deribit results (Figures 3 and 4), which does the regular integration method to calculate the implied volatility, yields the same results. We can see that the smart contract method generates the same results, but requires a bit more code / math than just the VIX formula quoted in the whitepaper. I have tried to be brief, and can go into a lot more detail. I’m not sure if I should post my Jupyter notebooks here or not.

My main concern is that the math can be transferred to Solidity (I believe they could, although I am no Solidity guru), or there are next to no options contracts for a certain expiration. This would then have to infer from the contracts that do exist at that point in time.

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Hey Verto, a 30 day annualized expectation of volatility can be created using the data from Derbit, just wanted to showcase a 7 day due to how quick crypto moves.

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I love this proposal. I would also love to see a similar follow up that is this same thing but tracks VIX in traditional equity markets rather than BTC/ETH. I think there is likely a lot of demand for people to use DeFi to get exposure to traditional financial vehicles.

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Hi @rshipp,

That’d be great to do, but wouldn’t be via on-chain data until options exist for that, like wTSLA or something like that.

Yeah, for now maybe it makes more sense to leave it to a project like SNX to create sVIX with an oracle.

@ampodgorski & @george

Just flagging the announcement from UMA titled “Introducing the dVIX protocol volatility token”

Here’s the dVIX methodology paper as well.

Would love to hear your thoughts on it.

Hi @verto0912, I’m at a loss to be honest. Their methodology is slightly different and uses a different formula, not on-chain data: at the moment they’re no different from Deribit’s ethVOL or the CVI.

We were in discussions with Set about building the dVIX with UMA. Now they come out with a Medium article 12 days after this post and backdate their whitepaper to be before our 2 April post. The whitepaper even says ethVIX but their Medium article doesn’t match this and seems to plagiarize our name.

[EDIT]: seems they’ve been established earlier, but just under the radar.