Opyn, a new DeFi product, has introduced an options-based insurance market for investors to hedge against black swan events and insure their Compound deposits. By leveraging options, the insurance mechanism is less centralized and more efficient than competitor Nexus Mutual.
Ensuring Security for DeFi Investors
Despite strong traction within the DeFi ecosystem, there is no shortage of risk when it comes to these protocols. Most of this risk may not be visible on the surface, but they exist within layers of code, waiting to be exploited by malicious actors or sealed by enthusiastic bug bounty hunters.
Nexus Mutual, DeFi’s first real crack at tackling insurance, has about $3.6 million worth of value locked in the protocol.
A common criticism of Nexus Mutual, and even Maker, is the need for human intervention to assess risk. Nexus Mutual requires humans to analyze claims to shakeout fraudsters. Maker’s risk reports for adding new collateral are also conducted by humans.
Rather than setting up as a mutual and incorporating in the traditional ecosystem, as Nexus Mutual has done, Opyn operates like a regular Ethereum dApp.
Utilizing the Convexity Protocol, Opyn leverages the customizable risk mitigation tactics offered by options contracts to create a peer-to-peer insurance mechanism. There are three key use cases for the protocol: protecting against adverse price movements, hedging risks related to the DAI peg collapsing, and insuring tokens, such as Compound’s cTokens.
While the first two use cases are important, insurance against Compound deposits promises much more traction than the others simply due to Compound’s prevalence as a leader of DeFi.
Say a DeFi investor has DAI in Compound’s money market, and this particular investor wants to ensure their funds are safe in the event that Compound or DAI collapses for whatever reason.
Opyn offers this investor the ability to buy options contracts for the corresponding amount of cDAI (Compound’s wrapped DAI token) held by them. Normally, to cash out of cDAI back into DAI, this investor would simply need to redeem these tokens on Compound’s interface.
Hypothetically, if Compound was compromised and funds in the protocol were lost, this investor with exposure to Opyn’s insurance derivatives could simply exercise their options contract and receive the pre-determined amount of funds.
This option would be a cDAI:DAI options, where cDAI is the underlying asset and DAI is the strike asset that the investor receives when the option is exercised. The conversion price of cDAI to DAI for the option is decided when the options are minted.
As a peer-to-peer protocol, the counterparty to the option buyer, or the option seller, is another independent entity – not the protocol itself. To sell options on Opyn, one must deposit a significant amount of collateral, similar to a Maker CDP or Vault.
This collateral must be more than the maximum risk that can be incurred by the seller.
While this mechanism offers clear benefits in efficiency and improves decentralization compared to existing insurance primitives, liquidity and mass counterparty risks are pertinent issues with regard to Opyn.
Sellers mint options, called oTokens by the protocol. oTokens with the same expiry date have interchangeable liquidity and are fungible with each other. oTokens can thus be sold to a third party who then bears the risk of the option being executed.
This strains native protocol liquidity, as each set of oTokens, with different expiry dates, must be a liquid market in itself. On the bright side, thriving options markets suffer from this very predicament, with certain strike prices and expiry dated contracts enjoying significantly more liquidity than others.
However, DeFi is a different beast relative to traditional markets, so it is unknown how liquidity will play out here.
Mass counterparty risk is another specific phenomenon. If the DAI peg collapses, or if a bug in Compound allowed a malicious actor to drain funds from the protocol, all option buyers would exercise their contracts at once, leading to a mass depletion of liquidity.
A regular automotive insurer, for instance, does not have to deal with mass risk on this level. One defect does not mean that every insured car ends up damaged or totaled.
Stock and commodity options-based insurance do have this same risk. If the price of crude oil steeply declines, put options will see a massive liquidity depletion as buyers exercise their right to sell at a higher price.
Advancement of Crypto Options
Options contracts for cryptocurrency have seen significant traction off late, with Deribit and CME leading volume with their BTC options.
As more sophisticated speculators enter the space, options are expected to gain traction as they offer a capital-efficient way to speculate and hedge against risk.
The use of options for more specific risk management processes like that of Opyn is a strong sign that crypto markets are gradually diverging towards the recreation of traditional markets in a permissionless, open manner.