An Introduction to Options Market MEV
For most DeFi primitives, such as lending, spot trading, and futures markets, there are a plethora of competitive venues to choose from. However, options markets have lagged behind these verticals from both a development and an adoption standpoint. The complexity involved in building a truly competitive options protocol is high. Only recently have a handful of protocols surfaced as potential solutions for on-chain options trading, but soon enough Siren Flow will be fully launched to bring on-chain options on par with the other DeFi primitives.
Major components such as the pricing mechanism, market-making process, and liquidity model are already in place, but on top of that, Siren is tackling one of the less talked about issues with on-chain options — MEV. This is the first installment in a series on the technical aspects of DeFi options, where we’ll lay the groundwork for understanding key issues and how Siren’s solutions are delivering a new standard for crypto options trading.
Options Basics: Understanding Calls and Puts
At their core, options are contracts granting specific rights:
- Call Option: Grants the holder the right to purchase an asset at a predetermined price at a future date.
- Put Option: Similarly, it allows the holder to sell an asset at a predetermined price at a future date
This predetermined price is often referred to as the Strike Price, and this future date is often referred to as the Expiration Date.
The price of these options is determined by the laws of supply and demand. In an efficient market, the price of these options, roughly speaking, is the market’s expectation of what the option may be worth in the future. Assuming an efficient market, if the option is worth more than this expectation, the sellers may step in to bring the price down, likewise, if the price is below this expectation, buyers may step in to bring the price up.
This value is split into 2 components: Intrinsic and Extrinsic Value.
For a European option, Intrinsic Value refers to what the option is worth based on how much it is worth if it were to be exercised right now. For a European call, this is the positive part of the underlying asset’s current price, less the strike price. For a European put, this is the positive part of the strike price less the underlying asset’s current price.
Extrinsic Value is a premium the option carries before expiration, which in an efficient market should reflect the additional expected value generated by the optionality of the contract. For a standard European call or put, this is the market’s expectation of additional value that could be created by the option expiring further in the money.
The value of any European option can always be described as the sum of its intrinsic and extrinsic value. A European option can never have negative intrinsic value and can never have non-positive extrinsic value prior to expiration.
Option Market Making: The Traditional Landscape
For there to be liquidity available for people to trade options, there needs to be a medium of exchange. In traditional markets, buyers and sellers come together, haggling over price, in turn creating a market. Individuals and institutions known as market makers will enter these markets and agree to buy and sell options to and from market participants, effectively bringing together buyers and sellers. In effect, market makers form a medium of exchange by facilitating liquidity. Market makers are crucial in options trading, providing market liquidity. They manage risks and secure profits through strategies like Delta hedging, which involves balancing a portfolio by offsetting options positions with positions in the underlying asset. Highly accurate Delta hedging is a key component of Siren Flow’s architecture, more on this later.
Decentralized Trading: A New Era for Options
DeFi transforms options trading by digitizing and decentralizing the process. Options become tokens on smart contracts, carrying details like maturity, strike price, and underlying asset oracles.
Once a token standard is created in DeFi, buyers and sellers can come together, similar to traditional markets. Options are bought or sold either through agreements made OTC or through a Swapping Protocol.
The caveat in DeFi is that there tend to be many more avenues of exchange, chains, protocols, token standards, etc. Not to mention, in most cases, DeFi derivatives are without legal recourse, which means that a DeFi protocol without access to legal recourse must require collateral from market participants to be able to operate in these products. This creates additional layers of complexities, which option protocols must address. With a clear view of DeFi options basics, we can now take a look at Siren’s approach.
Siren Flow Architecture
Siren Protocol operates as a Decentralized Options exchange allowing users to buy and sell options on ERC-20 tokens. Users can trade a variety of vanilla options and more complex spread strategies such as straddles, strangles, condors, etc. Users can implement both credit and debit spread strategies.
When users come to Siren, they begin by connecting their wallets, selecting options, and executing trades through a Request for Quote (RFQ) system that combines on-chain execution with an off-chain hedging pricing engine.
On the backend, Siren will (potentially depending on the specific strategy traded) collect margin and then execute a delta hedge to keep the system as close as possible to being delta neutral.
Delta Hedging in DeFi
Delta hedging remains a key strategy in DeFi. Similar to TradFi, an options market maker in DeFi must provide some sort of hedge for the position expiring in the money. You can think of a delta hedge as simply buying some amount of the underlying asset in the opposite direction of your trade. While there are a variety of approaches, for the Siren Protocol, we hedge our options pool via a dynamic strategy implemented with perpetual contracts. You can think of a Perpetual contract as being similar to a futures contract with constant daily resettlement and no maturity. Siren trades these perps in a quantity, in our view, that will keep the portfolio approximately delta neutral considering the term structure of the pricing surface. While this may seem complex, we will be breaking this down further in a series of articles to come.
Pricing Strategies and MEV in DeFi
For most DeFi option protocols, there are 2 primary sources of MEV risk: (1) MEV with the collateral system and (2) MEV against quote prices.
To understand how MEV can be generated, it helps to think along the following lines: How can I get more money out of the system than what I put into the system, ideally in 1 block, and without taking any risk?
Addressing Collateral MEV
With respect to margin on options protocols, the following statement must be globally met: It may never be the case, such that through a series of trades, a user can receive an upfront payout larger than the margin required by the system. If they could, this would be free money to the trader.
At Siren, we have adapted our margin system to always require a margin greater than the credit paid on a credit spread within a single block. Thus, a trader can not earn a MEV profit on our Margin System by trading options in such combinations in vulnerable market states.
Pricing Related MEV
With respect to an options protocol’s pricing system, it absolutely must be the case that under no circumstances may a user trader options in a combination that returns a credit without taking price risk. ANY OPTION PROTOCOL THAT ALLOWS THIS IS EXPOSING THEIR LP’S TO SIGNIFICANT LOSS OF FUNDS.
At Siren, we are coining our pricing approach as “MEV Free Pricing”. MEV Free Pricing, simply put, is a pricing technique that ensures that at no time, a trader trading with Siren Protocol can generate a risk-free profit, at the expense of Siren’s LP’s. This is achieved through complex considerations about the structure of the pricing surface. To our knowledge, Siren’s MEV Free Pricing Technique is unique, and similar techniques are not implemented among competing protocols. We will discuss these considerations over a series of articles as we lead up to our public mainnet launch.
Conclusion and Upcoming Topics
As we lead up to our public mainnet launch, we will be continuing this series of articles to discuss some of the nuances around:
1. MEV Free Pricing
2. Delta Hedging
3. Maximizing Capital Efficiency
By addressing these issues with robust math-based approaches, we believe Siren will lead the market as a top RFQ options protocol. We look forward to working with our community closer in the coming months as we onboard users to private access, collect feedback to fine-tune the platform, and ultimately conduct the full public launch.
For those interested in an early trial of Siren Flow, sign up here: https://siren.xyz/flow
About the Author:
The content of this technical blog series is written by Rashad, Quantitative Lead at Siren. Equipped with a Master’s in Computational Finance from Carnegie Mellon and a Bachelor’s in Mathematics with a Minor in Computer Science from Hofstra University, Rashad’s passion for Crypto, Math, and Finance ignited during his college years. As an early intern at Bitcoin Center NYC, he deepened his understanding of Crypto and honed his finance skills at TradFi institutions like PNC Bank and DoubleLine Capital, where he focused on risk assessment for Auto Loans and Commercial Mortgage Backed Securities. Following his graduation from CMU, Rashad further refined his quantitative expertise in the realm of energy derivatives at Xcel Energy and solidified his DeFi knowledge as the former Data Science Team Lead at RociFi. A seasoned hackathon participant, Rashad has competed at ETH Denver, ETH Global, and Permissionless. His proficiency in option valuation, data analytics, and smart contract development is complemented by his unwavering advocacy for DeFi and Zero Knowledge Tech, driven by a vision of democratizing access to financial tools. Connect with Rashad here: https://linktr.ee/rashadh
