For traditional wealth management clients, structured products have long ruled the roost. Powerful callable securities, in particular, have long been favorites with investors, providing them with a cushion of downside protection combined with upside exposure to single stocks or baskets.
Over the past year, however, the crypto industry has been quietly working on its own versions of structured products that are getting more and more sophisticated as the months go by.
These have largely existed in a corner of the crypto landscape known as decentralized finance (DeFi) – meaning unrelated to any centralized exchange such as Binance or FTX. Instead, the investor uses smart contracts to conduct the investment strategy on their behalf.
While a centralized platform may restrict users from using derivatives depending on the regulatory status of its jurisdiction – for example, UK retail users cannot trade crypto futures on most large centralized sites – DeFi has no such restrictions. This means that users can access sophisticated derivative strategies that would otherwise be beyond their reach – for better or for worse.
The original crypto structured products were housed in DeFi options vaults (DVVs). Users deposit crypto anonymously into the DVVs – be it stablecoins like tether or USDCor assets such as Ethereum (ETH) or bitcoin – and the DVVs go out and execute an investment strategy on behalf of investors.
the original DVVs executed simple strategies of buying or selling covered put options. The first and largest protocol offering DVVs is Ribbon Finance, with $78 million in its DVVs to November 4, according to the aggregator site DéfiLlama, down from a peak of over $300 million in May – before the start of the so-called crypto winter. Other larger protocols include Thetanuts and StakeDAO, which also offer similar products.
The ETH covered call DVV at Ribbon takes deposits in ETH and sell out of course a week ETH calls 10 delta to earn the bonus, which amounts to approximately 0.25-0.45% per week. If the options end in the money, the premium is lost and the rise in the underlying ETH the asset is effectively capped. Investors are always exposed to the underlying ETH lose value, however.
Vending Vaults typically see the user deposit stablecoins into the DVV, who writes put options down and collects a premium. These are a little riskier, as there is no natural compensation if the put options expire in the money.
Options are auctioned at 9 a.m. UTC on a Friday. However, since the size and timing of the options sale is well known in advance, market makers can anticipate the flow. Weekly implied volatilities ETH options at the time of the auction are usually about four flights below the previous 24 hours, according to Paradigm research.
According to their research, this equates to approximately 0.1% lower premiums, or 5.35% per year in missed earnings. Market makers who buy the options, on the other hand, say they need to position themselves for these flows, which some say are responsible for around a quarter of the total crypto options volatility supply and are trading in numbers. in billions of dollars of notional amounts each week to certain market makers.
This raised questions as to whether the DVVs fell victim to their own success and led some to wonder if further expansion was possible. Ribbon, for example, considered holding more random and unannounced intra-week auctions, but this raised concerns among market makers that they would not be able to handle the flow without sufficient notice. In its research note, Paradigm suggests pre-announcing but staggering the auction to lessen the impact on implied volatility.
But despite these growing pains, companies were undeterred and instead sought to create new, more sophisticated strategies.
Ribbon launched a principal-protected product in August, which derives a return from loans USDC deposits to market makers such as Genesis and Wintermute and uses part of the interest payments to buy weekly out-of-the-money barrier options at around 8% up and down. It offers a base return of 4% with a potential return of up to 13%, depending on whether the options end in the money or not.
The question now is where crypto-structured products can go next. Those in the know say the end game for companies like Ribbon is to offer the full suite of private banking-like products, including autocallables.
Some suggest they could disrupt the TradFi private banking market, but with a broader base given the lack of a minimum wealth requirement to invest. However, after the crypto troubles earlier this year, the assets under management of companies like Ribbon took a hit and have remained fairly stable ever since.
On the institutional side, many companies are bullish in this space. Over the past year, a number of them have sprung up to serve institutional clients looking for structured crypto investments without necessarily wanting to dive into DeFi themselves or need bespoke structuring solutions. These companies include OrBit Markets and Enhanced Digital Group, which were founded by former derivatives traders at major sell-side banks.
If institutional investors rediscover the interest in the space they showed before the onset of the crypto winter, who knows where it might lead?