Product Proposal: Launch The Option Index ($OPTION)

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Product Proposal: Launch The Option Index ($OPTION)

IIP: [to be assigned]

Title: Launch The Option Index

Status: Proposed

Author(s): @afromac, @ahuja

Discussions-to: ‌https://gov.indexcoop.com/t/product-proposal-launch-the-option-index-option/3350

Simple Summary

The Option Index enables users to execute a diversified yield strategy composed of covered call and put options on Layer 1 blockchains such as BTC, ETH and a number of blue chip application layer protocols such as AAVE. This original iterations is exclusively focused on the vaults developed by ribbon.finance but there will be scope to include vaults/strategies from other protocols in future.

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Abstract

Ribbon Vaults have proven to be a popular and effective strategy for yield generation in DeFi. Their covered call vaults have generated APY of 10-20%, while their put vaults are currently generating 30+% APY. A risk adjusted basket of these assets enables a user to gain diversified exposure to the most popular cryptocurrencies while simultaneously making those tokens productive by writing puts and covered call options. As such the assets will generate yield in all market conditions, and only be at risk of loss during the most volatile markets. The put writing strategy has no price volatility exposure of the underlying token as it uses USDC as collateral. The covered call strategies have underlying token price exposure where risk is moderated by selecting and weighting the various strategies based on the price performance of the underlying token.

#‌# Motivation

DeFi users want yield. While there are a multitude of excellent extrinsic productivity options for our customers, we are still many months away from enabling intrinsic productivity in our products. Ribbon Finance have already solved this problem on their protocol. As all claims on a vault are represented by an ERC-20, we can benefit from their technology by simply wrapping their rETH-THETA, rBTC-THETA (etc) tokens in a Token Set. This creates an exchange tradeable basket of assets that can earn as much as 15-25% APY while granting exposure to the most popular cryptocurrencies. Time to market should be short and the opportunity is massive.

LPing a position of OPTION-ETH should be an extremely lucrative strategy.

Specification‌

Overview

Ribbon vaults generate yield by running automated covered call and put strategies on Opyn. As of Version 2, all logic and execution happens on-chain. Each Friday deposited collateral is used to write puts and covered calls, with all income accruing back to the vault each week. The earned income is reinvested in the following week’s strategy to earn further yield. The compounding of returns is implicit in the mechanism, and all income is denominated in the collateral asset.

The product user will allocate capital into a basket of Ribbon vaults that is optimized for risk and return. This reduces the gas and transaction cost that would normally be required to initiate a similar strategy manually. Additionally, it removes the burden of managing the position as the composition of the Index will be rebalanced back to the risk adjusted ratio at regular intervals, locking in gains and reducing risk.

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Differentiation

If launched this should be the first Index Coop product with yield generation enabled. This makes the product highly attractive to DeFi power users. Crucially this customer is differentiated from PAY (retail) and LDI (DeFi treasuries) customers in that it targets DeFi degens and yield hunters. Additionally, the product generates income from a trading strategy that introduces additional risk.

Product Target Customer Composition Risk level
OPTION DeFi Native Concentrated Crypto Blue Chips Moderate
LDI DeFi Treasury Diversified Portfolio Low
PAY Retail Stablecoins Very Low

Example composition

An example composition of the index is as follows:

Strategy Collateral Token Weight
Stablecoins - 30%
T-USDC-P-ETH USDC 30%
Layer 1 Blockchain Tokens - 60%
T-ETH-C ETH 41%
T-WBTC-C WBTC 19%
Application Layer Tokens - 10%
T-AAVE-C AAVE 10%

Size of opportunity

Yield generation strategies are fundamental to DeFi. A protocol such as Yearn commands $4.43B TVL (1.5M ETH & 102.8K BTC). By comparison, Ribbon is a smaller and quickly growing protocol with a tremendous potential upside. Having grown to a $204.8M TVL (67.7K ETH & 4.8K BTC) since launching in April 2021, Ribbon has emerged as a highly popular source of revenue for DeFi power users. Combining their tech with Set Protocol’s infrastructure and Index Coop’s asset management capabilities is a natural fit and should lead to a profitable and gas efficient product that drives high demand from new customers.

Market & Customer Research

Target Customer

What audience is this product intended to appeal to? What other products are this audience using right now? How is this product a better fit or unique alternative?

  1. Knowledgeable DeFi users seeking gas efficient exposure to Ribbon’s vaults
  2. ETH and BTC holders seeking straightforward yield generation on a concentrated portfolio of Crypto Blue Chips
  3. Customers with a moderate appetite for risk who are willing to capital towards an automated options trading strategy.
  4. Tax and attention saving for long term passive holding.

Methodology

As explained above, the index will be composed of a mix of tokens each made productive by depositing in a Ribbon vault strategy.

The allocation constraints for the various strategies are defined as follows.

Stablecoins

  • Stablecoins based strategies should not exceed an allocation greater than 30%.
  • In case multiple strategies exist such as writing puts on multiple tokens, individual weightings will be determined based on the annualized yield and the sustainability of the yield with those strategies.

Layer 1 Blockchain tokens

  • Strategies that use ETH, WBTC or other Layer 1 tokens as collateral should not exceed an allocation greater than 60%.
  • The individual weights of the tokens within this category will be determined based on their Sortino ratio as outlined below. The weight assigned to a token is directly proportional to its Sortino ratio.

Note that Sortino ratio as calculated here is the ratio of the annualized % return and the annualized % downside deviation. The ratio is calculated based on the daily price movements of the token in the past 12 months and then scaled to obtain annualized values.

Token Sortino Ratio Weight within Category
ETH 8.08 69%
WBTC 3.67 31%

Application layer protocols tokens

  • Strategies based on individual tokens belonging to DeFi, Metaverse or other themes should not exceed 30%.
  • No individual token should exceed 10% of the index.
  • The individual weights of the tokens within this category is directly proportional to their Sortino ratio. At present time, there is one covered call strategy based on the AAVE token. So, allocation of this category will be limited to 10% which is the maximum allocation allowed to any individual token in this category.
  • If, at any time during initial composition or periodic rebalance, there are insufficient number of active vaults available to make up the 30% weighting, the previous category of strategies based on layer 1 tokens will be adjusted upwards to make up for the difference.
Token Sortino Ratio Weight within Category
AAVE 2.57 100%

Note that if the weight requirement of a particular strategy cannot be met due to size limitation of the Ribbon vault, the weights of the other strategies will be adjusted upwards to accommodate for this.

An example composition of the OPTION index is as follows:

Strategy Collateral Token Weight
Stablecoins - 30%
T-USDC-P-ETH USDC 30%
Layer 1 Blockchain Tokens - 60%
T-ETH-C ETH 41%
T-WBTC-C WBTC 19%
Application Layer Tokens - 10%
T-AAVE-C AAVE 10%

Index maintenance

OPTION will be rebalanced every quarter based on updated metrics. Additional rebalancing or readjustment will occur as needed if a Ribbon vault strategy is closed or retired.

Costs

Cost to customer

Index Coop will charge a 0.95% streaming fee. Ribbon will charge a management and/or performance fee on the underlying vaults based on the weekly performance.

Cost to mint / redeem

Provide an estimate of the gas price to issue (*Can be omitted from DG1)

Rebalance frequency

Manual per quarter

Liquidity

The suggested pair for liquidity is OPTION:ETH. The provisioning of initial liquidity should be deployed for IC’s treasury and placed in a managed Uni V3 Visor Vault similar to IIP-109. This should assist in the diversification of Index Coops Treasury, and enable the supply of liquidity to become an income generation activity by Index Coop.

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‌Author Background

This is an internal methodology proposed by the AI Pod. The AI pod is a multidisciplinary team that works to support leveraged products for Index Coop. We have developed a roadmap of internal products that execute automated income generation strategies that we will be sharing with the community in the coming weeks.

Revision history

Describe any modifications to this proposal since the original post on the forum

Copyright

‌Copyright and related rights waived via CC0.

16 Likes
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I think this is a great idea. I have a few comments/questions:

  • The appreciation will be lower relative to standard tokens because you’re selling the upside to the call buyer when the option expires in the money. Do you expect that OPTION would outperform its standard counterpart after yield? At the very least, the reduced appreciation should be disclosed to customers. For reference, most (but not all) option ETFs underperform their standard counterparts even after yields.
  • There’s a chance the yield and/or exercise price will decrease over time as uptake increases. Do you have a sense of how stable these are?
  • I’m not aware of any evidence that Sortino-optimization improves risk-adjusted returns. Even Dr Sortino doesn’t believe in his own ratio. It might be worth considering naive or mcap weighting instead.
  • Given the recent attention to the cost and NAV decay (>3.5% for MVI !) for rebalancing and the increased visibility is there an argument for not rebalancing at all (equivalent to mcap-weighting) or rebalancing based on large thresholds? I think it’s particularly relevant for this product since the NAV decay will eat into the take-home yield.
  • Similarly, the rebalancing costs and NAV decay from entering and exiting new and retired vaults could be very large. Is there an option to stay in a vault and just ride the standard return until a new vault comes?
  • I think a buffered index with capped downside using at-the-money puts would be very popular.
  • Assuming we plan to release a series of these products, I’d suggest a more brand-able name family than"OPTION", eg, Enhanced Yield Large Cap (EYLC), Enhanced Yield DeFI (EYDFI), etc.

This is exciting and I’m looking forward to where this new platform take us.

7 Likes
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Thanks Joseph. Let me address your comments

  • The approach is to use a combination of option strategies including puts & calls. These strategies (both put & call) are exclusively short duration options with conservatively chosen strikes (but still priced low enough to benefit from the high vol). The Ribbon backtesting data shows a < 5% chance of the calls expiring ITM. Additionally, the conservative strike will reduce the magnitude of payout from the vault in the low probability event that the option expire ITM. Any such payout is expected to be more than compensated by 1) the compounding effect of earlier yield generated as generated yields are allowed to compound. 2) The yield generated from put writing strategies for the same or similar tokens.
  • The index will monitor and include additional vaults (that are suited to the index strategy) from Ribbon and similar such protocols. Special care will be taken to include strategies that offer diversification benefits or downside protection to the index as a whole. If a vault ‘consistently’ underperforms due to either diminishing yields or token price, the weighting will be adjusted.
  • Sortino ratio offers a measure that accounts for estimated negative price vol. Having a measure that is based on volatility should suit weighting various options strategies. Ex. smaller price fluctuations directly impact options payouts.
  • We do want to keep the NAV decay due to frictional costs (rebalancing, etc) at the minimum. That will remain an important consideration. Each quarterly review may not result in any rebalancing action or may be a small rebalancing action but having periodic review is important.
  • Decision to exit or enter a strategy or vault will be determined based on overall impact and value to the index. Yields just like options pricing will having fluctuations and have a structural/cyclical component to them. Having said that, this is just like other open markets where returns move with demand/environment i.e. lending. The index’s approach is to not move in and out of strategies/vaults on a frequent basis.
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Thanks Ahuja. I’d recommend communicating that the yield is coming in exchange for reduced upside which wasn’t clear from the original post. Missing ~5% of ETH’s best weeks can add up. Congrats again on a great proposal.

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Hey guys, appreciate the work on this proposal. Here’s some immediate feedback:

  • I’ve been a regular user of Ribbon myself and I am not sure why I would use this product vs the ribbon vaults directly? Fungibility? I feel like Market & Customer Research doesn’t necessarily target DeFi degens. Have we seen real demand for a product like this or are we developing in it based on hunches?
  • Why don’t we also use StakeDAO options? They have currently higher yields and work pretty much the same afaik. The management & performance fees on Ribbon are already tough and the more we rely on them, the more lockin they generate.
  • I am sure you already know this, but Ribbons APYs are a bit misleading. Their actual BTC call vaults performance is negative (-1%) so far.
  • I love options and think the structured space for them is going to explode in the next 6-12 months. Diving in early here will get us a good head start.
4 Likes
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This is a pretty cool idea!
Great work @afromac @Ahuja

A couple questions around the methodology which I can’t figure out based on the information presented above.

  • How was the Tactical asset allocation profile determined ? (If intended to be a risk on product, perhaps a cash allocation is mis placed, the rebalancing from high vol dapps into cash with such aggressive yields could be quite expensive to execute)
  • How will the supply caps be managed if a vault is near capacity and a uses tries to do Exchange Issuance ? Does this mean Exchange Issuance would have limitation ?
  • When arb bots try to bring OPTION back to NAV and the underlying assets positions, Ribbon vaults, are at capacity, how would this work ? The arb bot won’t be able to attain the underlying position to then Mint OPTION.
  • Would there be a fair amount of spot deviation from NAV due to the fees on exiting Ribbon vaults. To arb the pool down to NAV the constituents would need to be withdrawn from the Ribbon vaults and this triggers a fee.
  • A safe launch for this products to me feels like it need a circulating supply cap whilst the Ribbon Vaults have caps. Otherwise, additional yield diversification strategies are needed and the composition of the product is less periodic rebalancing, but also driven by constituent constraints.

More a visionary like question, but can the writing and selling of Put / Call options, ie: what Ribbon does, be performed in-house ? Is there a way to mitigate incurring a Yearn Fee (yUSDC), then Ribbon Fee (upon withdrawing) and Index Coop fee (holding).

If we solve this chest nut, then the market potential is a lot larger. Index Coop can replicate Yearn strategies, could Index Coop then write the options, sell the positions like Ribbon does to Opyn and then bundle up those derivatives into a product. Seems like a good way to eat someones lunch. All be it a rather large vision to execute, or potentially kick back deals can be done. Then the Index Coop fee is lower, but net revenue is higher due to kick backs through Yearn and Ribbon.

5 Likes
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Hi Christopher, Thank you for your feedback. The index will be flexible in its allocation across different protocols that are value add either from the standpoint of token exposure and/or better net yield (net of cost). This includes StakeDAO. In addition, please note that we have been doing our own backtesting to quantify the probability of chosen strategies expiring ITM. To the extent, other vaults or strategies are better suited, we will revert to those in future pending integration of those protocols within our product. The utility of this token increases as more tokens/strategies/protocols continue to be added offering even more diversification benefits.

In my opinion, a token holder of this index gains convenient exposure to variety of options strategies (benefiting from put/call & token diversity) i.e. it is a convenient way to hold a group of highly productive tokens. Please note that the collection of tokens are chosen & weighted based on their expected total return & price volatility.

1 Like
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Hi Mat, Thank you for your feedback. The motivation of having a highly productive cash position is that it allows significant diversification benefits of writing puts while the remaining portfolio focuses on covered calls. This provides a means to cushion or soften any impact of covered calls ending ITM for a particular week. Additionally, providing exposure to a low vol approach to earning high yield for a part of the portfolio.

If a vault is near its supply cap, an approach is defined in the post where in the weighting of the other vaults will be adjusted upwards. It is our intention to include multiple vaults with the same or similar strategy so we do not run into supply cap issue. Additionally, we can also explore with the underlying protocols having a vault dedicated to this index. I agree that supply constraints will need to be managed by a combination of having redundancy within the index constituents to fall back on and rebalancing.

To your last point, pending integration with on-chain options exchange like Opyn, in house vaults can be spun up. This was discussed in the product team.

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This kind of reminds me of S&P 500 covered call ETFs

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Excellent point Matt, and glad you brought this up. IC having the native functionality to write and sell options ourselves opens up a lot of possibilities, but like you mentioned, is contingent on an investment in engineering resources. What this product is designed to achieve, and what this entire forthcoming product stack by the AI Pod is focused on, is being able to quickly move into markets that we have not explored by leveraging the tech already created by other teams, and marrying it with the functionality that we already have today.

A Token Set is simply a basket of ERC20s. The majority of Token Sets that IC has created to date have been comprised of governance tokens, but ERC20s are used to represent many other complex instruments in DeFi - such as the Theta Vaults as described in the proposal (Like @Ahuja mentioned, vaults from other protocols are also suitable for inclusion and we will explore this possibility for future revisions). The advantage of the strategy that I am proposing, is that it enables us to reduce the engineering workload to introduce these complex feature, and tap into those unexplored markets by wrapping these more complex investment strategies into our Token Sets. We will have to create new modules to implement these designs, but we will not need to completely remake the functionality from scratch

This is a product category we are defining as meta-structured products. By being strategic in our design choices and choices of partnership, we can move far more quickly as an organization than we have previously. I don’t just think this is an advantage, it is a requirement for Index Coop to successfully navigate the next couple of years.

Our product pipeline moves too slowly - we spend too much time negotiating, and we allocate too many engineering resources to requesting ad hoc design features. We are already falling behind competitor teams like Beverage Finance, and Index Coop is now the explicit target of a vampire attack by Enso. IC needs to move far more aggressively to maintain our leading position. Nothing in business is guaranteed, and while we have a notable lead now, so did Myspace in 2009.

So this is not just a product idea, it is very much part of an overall strategy to reorient our business model and be far more proactive in our roadmap choices, as well as far more strategic in our use of engineering resources.

By focusing on these kind of products, we can quickly move into other categories such as:

  • Fixed Income/Lending
  • Real World Assets
  • Staking
  • Market Making/Liquidity
  • Basis Trading/Market Neutral

The underlying philosophy is that by simplifying access to these kind of income strategies, we can abstract away much of the complication and barriers to entry for the normal investor. Instead of an investor having to call the structured products desk at Goldman Sachs, by creating a diverse offering of automated products, Index Coop can bring these kind of opportunities to everyone. This should be a central part of our mission to simplify investing and provide financial opportunity to everyone equally.

The AI Pod is preparing to present more of this product roadmap and overall strategy in the near future.

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