May 10, 2022

Dopex Papers: Interest Rate Options (Technical)


Dopex: Rate vaults, CRV and CVX

For all the talk of a lack of innovation in DeFi, Dopex continues to strive to deliver fairly innovative solutions to the market whilst solving problems and creating new market dynamics that build entirely new target vectors within the space. Interest rate vaults fall within the latter.
A thriving and liquid IRO (interest rate option) market that allows market participants to purchase/write options for Curve gauge reward APYs brings an entirely new dynamic into the space.
For the sake of catering the article to *anyone*, I’ll go on a brief explainer on Curve, veCRV, Convex, vlCVX and gauge rewards. Quite a mouthful isn’t it?
Curve: A protocol that allows for low-slippage, high liquidity stablecoin swaps between different flavors of stablecoins and more recently with Curve v2 an AMM (automated market maker) for crypto assets as well. The largest TVL protocol with its flagship governance token, $CRV, with the best-designed tokenomics in the space.
veCRV: or vote-escrowed $CRV. CRV tokens are lockable up to 4 years. The longer CRV is locked, gives lockers a higher amount of veCRV. 1 CRV locked for 4 years returns 1 veCRV, 2 years — 0.5 veCRV, 1 year — 0.25 veCRV and so on. veCRV gives voters rights to participate in Curve governance as well as vote on “Gauge weights”. veCRV holders are also distributed 50% of all fees generated across Curve.
Gauge weights: CRV tokens are emitted to liquidity pools on Curve via “Liquidity Gauges”. These gauges receive a portion of weekly CRV reward emissions (around $12m at the time of writing) relative to the gauge weight percentage of each pool vs the total gauge weight of all pools.
The purpose of these emissions is to attract liquidity to stablecoins and assets looking for a return on parking their assets in exchange for helping the pool hold its peg.
Convex: Considering the fact that veCRV is locked and not tokenized, it can be pretty daunting for regular users to lock their CRV over 4 years and creates an uneven playing field skewed towards users with larger portfolios who could write off 4-year locks at a blink of an eye. Convex fixes this with their protocol token, CVX.
Convex allows users to lock their CRV perpetually in 4-year locks in return for cvxCRV — a tokenized form of veCRV with no governance powers, but access to staking/yield farming opportunities.
vlCVX: CVX holders can lock their CVX for 16 weeks and get access to vlCVX or “vote-locked CVX” which gives them access to the veCRV locked by Convex. At the time of writing, each vlCVX gives the holder the equivalent of 4.71 veCRV in governance/gauge weight voting power.
yVeCRV: Just kidding, we have nothing to do with this. But..
Why veCRV?
Let’s do some quick math — say we’re launching a stablecoin, nuUSD and we’d like to collateralize 1 USD based on the floor value of 1 Nu DiamondPepe NFT, which in this hypothetical scenario is a 100 ETH. Assume we use a 30% loan-to-value ratio, which means the borrower can borrow up to 30 ETH worth of nuUSD.
Now, what’s the use of a stablecoin if you can’t exchange it for real dollars? Well, maybe we can spin up a Curve “Factory” pool that allows nuUSD to be paired with 3pool — an LP token consisting of USDC, USDT, and DAI — which is widely accepted across crypto as the best proxies for a dollar today.
Now, we create this pool and seed it with say a 100k nuUSD and 100k 3pool. We launch our nuUSD minting vaults. People mint nuUSD and immediately dump it for 3pool and leave you with a fat bag of nuUSD with 0 liquidity on the 3pool side.
What? This isn’t how it’s supposed to work. How are there a bunch of pools with billions in liquidity right now? Well, it’s because of incentives. In the form of CRV. Generated how? By emissions. From where? From veCRV holders who vote on gauge weights for different pools.
The CRV emissions in Curve pools along with its amplification factor and “StableSwap” protocol have proven to be the best tool for stablecoins to hold their peg — which’s what has lead to a battle for veCRV voting power, which has more famously been branded as
The Curve Wars
Whales, DAOs and groups of friends have been acquiring/bribing/lending veCRV with the ultimate goal of increasing CRV emissions to specific pools to help increase their liquidity and strengthen their pegs. Coupling this CRV emission effect along with Curve’s stableswap protocol has lead to stablecoins being a lot “stabler” and antifragile against de-peg events.
For example, in January, MIM or Magic Internet Money — a CDP (collateralized debt position) based stablecoin that was minted by using existing interest-bearing assets as collateral came under heavy pressure of a de-peg event when it’s co-founder, Sifu, was outed to be associated with QuadrigaCX in the past.
Unaware of Sifu’s involvement with MIM — and for some reason thinking he would be able to steal everybody’s assets there was a rush for the exits with MIM holders swapping their tokens against the MIM/3pool LP until the ratio was 96/4 for MIM/3pool.
Surprisingly the $1 peg held considering the pools’ Amplification factor was set at 2000 (let’s just say it makes it a lot stronger against de-peg events) and as the panic was setting in, smart money saw the increase in CRV rewards APY from a large drop in assets locked in the pool and they rushed to replenish the lost liquidity.
This was probably the best example of how good Curve is at what it does. If StableSwap’s weren’t available or the liquidity gauge with CRV emissions — the pool would have de-pegged resulting in large amounts of losses and an uncountable amount of damage to the DeFi ecosystem from a trust and safety perspective.
But what’s the big deal? Why are people interested in this boomer non-triple digit yield and why do people even want these CRV emissions?
Well, let’s just illustrate it with some simple math. I’ll even round up some of the numbers so none of it looks too scary.
Some Math
Today around 691k CRV are emitted daily for liquidity providers. Which totals to around 4.8m CRV a week. In USD terms at the time of writing with a CRV price of $2.4 — this adds up to around $11.5m in emissions a week.
$11.5m doesn’t seem too eye-popping considering Curve’s $20B TVL. Well, let’s multiply that by 52 for the year.
Whoop, that’s ~$600m.
Okay, it’s starting to make more sense now. But $600m/$20B is only about 3% annualized in rewards across all Curve pools — are people happy with providing that much liquidity for a paltry 3%?
Remember those gauge weights from before? And how relative gauge weights are used to calculate how much % of emissions each pool gets every week? Well, that’s how a few pools get a larger share of the pie compared to the others. How large? Maybe 20% of all gauge weight like FRAX? That amounts to $120m in emissions (at today’s prices) for FRAX pool depositors — which’s pretty insane and probably the reason they’ve accumulated about $3B in TVL.
Now does it make more sense? CRV’s aggressive emission scheme giving veCRV voters the right to vote on weights for pools’ liquidity gauges which get further diluted as time goes by thanks to more CRV being added to circulation — bringing about this elaborate flywheel, where every major player needs more CRV - to give away more CRV and somehow have a plan on maintaining their stake from losing its % with the inflation schedule.
This has been the play for months now and treasuries have been accumulating CVX and/or bribing veCRV/vlCVX holders to get the maximum bang for their buck in terms of gauge weight votes while staying liquid.
It’s the perfect mechanism that scales with growth in its target market and with a lot more stablecoin projects slated to launch in the coming months — will be more relevant than ever.
Dopex claims to be the key to Curve wars while requiring no direct hold of CVX or CRV itself as protocol. How does an options protocol plan to have any say in this already successful flywheel that continues to suck in stablecoin liquidity and more participants in an elaborate game of accruing veCRV?
Interest Rate Options
Unlike the options that we’re all familiar within the crypto space i.e vanilla call and put options that are bought for set strikes and settle based on a predefined expiry time — Dopex’ IROs offer the same but for annualized rates on CRV gauge rewards.
What? How does that even work?
I’ll explain that with
Some math again
And nice round numbers to not scare anyone away.
Unlike regular calls and puts, IROs are bought based on USD notional amounts rather than n calls/puts.
Now assume you have a Curve pool with 8% in rewards APY and you purchase $1m worth of weekly IR calls for this pool at the ATM (at the money) APY i.e 8%.
We calculate the premium for this purchase using a pricing formula, Black76, based on realized volatility of the pool APY over the year. For the sake of keeping this article simple — I’d suggest to just assume it’s another pricing formula similar to Black-Scholes.
Assume the volatility is 120% and the final premium for $1m worth of notional IROs calculated using the Black-76 formula equates to ~$100.
Add in fees at 0.5 bps (basis points, 1 bps = 0.0001) on the notional value. This equates to $50, making our total cost ~$150
Now at the end of the week, post gauge weight voting, if the APY for this pool shifts to say 10%. You would earn $1m * (10–8)% / 52. Which equates to $1m * 0.02 / 52 => $384. A profit of $234 or ~160%.
Okay, who would write for this kind of risk from just a 2% increase in price? Frankly, It looks a lot scarier than it really is. Dopex’ IR vaults are pretty cool since USD deposited for writing could be used to write both puts and calls at 100–500x leverage.
Say you’re farming a fairly stable Curve pool today with $100k at 10% APY. You could take $500 from your deposit and use it to write $100k worth of calls and/or puts at 200x leverage, earn weekly premiums and effectively “fix” your yield by capping your upside if rates drastically go up. Earning an extra $10 on your weekly yield on $100k @ 10%, amounts to an extra 5% on all earned yield.
Also, writers will earn a share of DPX rewards across IROs which would also be distributed using a gauge weight system similar to Curve through the use of veDPX — vote-escrowed DPX. More on this a bit further below.
This could realistically add a large multiplier on all earned yields depending on which pools you’re writing for.
Now imagine this scaled up to larger position sizes across protocols and participants that’re actively engaged in veCRV games. As some from the Dopex ecosystem may say, 1T (notional) TVL is not fud.
Scaling up
How much could such a market scale? Let’s take the existing Curve TVL of $20B. If we had to write IROs covering $20B with say an average of 250x leverage. Rate vaults would require $80m in deposits.
$80m doesn’t sound too hard at all to attract considering there are a whole host of DeFi protocols with over $100m in deposits. But for the sake of the devil’s advocates reading this — What would be the easiest way to acquire $80m in deposits?
The part where we mentioned earlier that writers would earn DPX rewards in a gauge weight manner similar to CRV emissions across Curve pools now.
Now the question is how much DPX would be needed to attract that much liquidity. Let’s take a ballpark figure of 3% in emissions overall prior to gauge weight splitting across all pools. For our target $80m TVL, this would amount to $2.4m/year or roughly around 2k DPX at current prices. Suddenly not too pricy at all.
Dopex has allocated 10k DPX in rewards for IR vault writers spread across their notional writing amounts — with larger multipliers for using lesser leverage.
Well, what are Dopex' plans once these emissions run out? Switching from DPX emissions to decaying bondable rDPX rewards.
An explanation would probably require another article but tl;dr they’re minted rDPX that can only be claimed by using it to bond for DPXUSD within a set time period. What does that mean? Pretty much that users get a free 25% arb on the market by claiming and bonding these tokens.
If you read up until this point and put 2 and 2 together, you probably realize that veDPX could emulate the veCRV effect and luckily we already have a Convex for Dopex being built in the form of Plutus.
But I digress, let’s get back to IROs.
Writing calls seem pretty attractive and a no-brainer if you’re already writing on a Curve pool with an IR vault. What about writing puts? Oh, and buying any of these options - who’s going to take the other side for these trades?
  • Rate option writing: LPs staked in existing fairly stable Curve pools who’re looking to earn an additional yield on their rewards could write both puts and calls to maximize premiums collected while earning an APY. It’s highly capital efficient and needs only 0.2% - 1% of your staked notional amount to write against it.
  • Rate option buying: Speculation and front-running gauge weight changes are probably the best reason to buy rate calls and puts that come to mind. Say you’re following governance proposals, bribing and other market discussions related to veCRV and feel you have an edge in knowing a pool may be moving a lot of votes in the coming vote.
    You can act on this info by purchasing calls or puts to profit from it. And depending on how you obtained the info — it would be branded as either frontrunning or speculation. A truly free market nonetheless. Well, that’s the intuitive and obvious reason to buy these, but there is another play.
  • Buying rate options as a proxy long/short on CRV: Ultimately rewards APY depends on CRV prices at expiry. Buying IR calls and puts on fairly stable pools are a good way to get access to speculative PA for cheap. For example, say we have a volatile week and CRV moves from $2.3 to $2.7 or ~17%. Say you purchase $100m worth of IROs for a $50m TVL Curve pool with fairly stable gauge weights having 1% pointed at their gauge — meaning they receive 1% of all CRV emissions for the week. As mentioned earlier in the article, this would amount to 1% of ~4.8m CRV or 48k CRV. Which equates to about 2.5m CRV annualized.
    At the start of the week, APY for the pool would be (2.5m * 2.3)/50m or about 11.5%. At the end of the week assuming no change in gauge weight, APY would be (2.5m * 2.7)/50m or 13.5%. A 2% increase.
    How could a 2% increase possibly be better than a 17% gain in CRV? Let’s take the $100m worth of IROs we purchased and calculate our PNL. Say overall premium + fees to purchase the options was around $20k. The value of the 2% gain comes around to $100m * 0.02 / 52 or $38.5k i.e a +90% on the initial capital. Before the thought crosses your mind, we do take a TWAP of it for our calculations at expiry to prevent any foul play.
  • Synthetic long/short rates: Using a combination of options allows users to creating synthetic long/short positions on gauge rate APYs. How? If you’d like to replicate the payoff for a long position: buy calls and write an equivalent amount of puts. And conversely for a short position: buy puts and write an equivalent amount of calls. These are of course constrained by time. This could also like the above strategy, allow you to speculate on CRV price changes in a far more capital efficient manner.
  • Fixed rates: LP farmers can “fix” their rates by writing ATM calls or buying puts at a rate they’re happy receiving if a pool is pretty volatile over a 1–2 week period.
  • Protocol level operations: DAOs holding a large amount of stables and veCRV voting power in their treasury can use a combination of the above strategies to earn a large additional multiplier on their farming operations. For example, pointing a large amount of CVX enabled voting power to different pools could earn them a large multiplier on their weekly yield and the pay-off for weeks of farming. I’d assume last-minute bribing operations before the gauge weight vote closes will become a thing considering the change in dynamics that IROs bring to the Curve wars.
  • Bribing: Bribes may be paid by protocols for IRO writers allowing DAOs to gain access to higher liquidity for strikes that favor their treasury strategies for the coming weeks. This is also a smart way for treasuries that are rich in their protocol tokens to “synthetically” cash them out for USD by front-running perceived changes in gauge weight voting power by paying out writers in their protocol tokens.
    The same bribing mechanics should come into play for veDPX holders who are in charge of voting in new rate vaults as well as setting their strikes and deciding DPX emissions for writers.
  • De-peg events: Buying calls on high gauge weight allocation pools that you expect to de-peg over a week or two gives everyone a chance to profit or hedge on these events.
For the sake of keeping the article from turning into a novel, I’ll probably stop with the strategies here.
Fees & veDPX trickle-down
Any flow within the IR vaults results in fees that are accrued to veDPX holders. How much? Let’s calculate with some conservative estimates.
As mentioned earlier, fees for rate vaults are set at 0.5 bps (0.005%) For every $100m in notional purchases, this equates to about $5k in fees. That doesn’t sound too great. Not really.
For example, if you consider the premium required to purchase $100m in notional at ATM strikes for a weekly pool at 8% rewards apy — $125k. It accounts for ~4% fees on the premium collected. Also assuming an average of 250x in leverage, to gain $100m in deposits would require only about $400k worth of deposits.
For every $1B in purchases assuming the previous example, fees would amount to about $1B * 0.00005 => $50k on the weekly pool. If a conservative 25% of Curve TVL or $5B in notional was traded across weekly vaults — we would be looking at about $200k in fees a week. Now we’ve to factor in bi-weekly vaults meant to coincide with Convex voting and I’ll leave the calculations up to your imagination depending on your thoughts on adoption.
Now of course veDPX holders will also be having access to a flow of bribes from participants who would like gauge weight votes for DPX emissions pointed to vaults of their choice. This could bring in another source of significant revenue for veDPX stakers. Maybe [redacted] could help us bootstrap these markets fairly quickly.
Curve participants adoption
Now unlike other Curve ecosystem products that directly interact with the Curve contracts and require whitelisting — and consequentially going through Governance, IR vaults don’t require any direct interaction with Curve and hence have no need to acquire any sort of permission from Curve ecosystem participants to work.
This effectively means that IR vaults pretty much needs just one participant using them in their favor and gaining an edge over everybody else in the Curve Wars to see a quick “adapt or be left behind” dynamic. veCRV users without a rate vault strategy would be effectively handicapped and blind to an entirely different dynamic that would not be visible from existing Curve or Convex workflows.
Personal views and TL;DR
The way I see it vaults would ideally start with mid-sized pools considering they’re the most “fertile” in terms of having adequate liquidity and being not too big that gauge weight voting changes would not require too much veCRV. Also attracting writer liquidity for these pools as well as profiting from them at expiry should be significant enough for mid to large size wallets.
Last-minute gauge weight voting changes, bribes and markets should become a thing to take full advantage of this dynamic. Splitting up veCRV locks across wallets could also become a thing to circumvent the 10-day lock on gauge weight votes.
veDPX bribes for emissions directed to vaults for pools and setting strikes with gauge weight votes from DAOs and other entities with significant veCRV should become a thing to attract more liquidity to these pools allowing them to take advantage of shifts in voting power.
Native token emissions from DAO treasuries for writers on these vaults by entities will also become a thing to attract higher liquidity for options of their choice.
Plutus could gain market share by positioning themselves as the “Convex for DPX”.
All in all, a good foundation is being set up for a rich rate options market priced in stablecoin that would be isolated from what’s happening with the rest of the market. Prices go up or down, strikes are adjusted to adapt.
Short-term expiries make it an attractive alternative for even smaller accounts to crazy leveraged perp trading sprees that usually end up in accounts blowing up.
100–500x writer leverage allows for markets to be bootstrapped fairly quickly while giving a larger scope for fees earned for veDPX holders.
The hedging aspect of it allows CRV LP stakers to “fix” rates and earn premium + rewards + bribes.
Other strategies will be innovated and more complex ones could spring up dapps of their own to help less informed participants to execute them with 1-click. I’m sure Jones will come up with a vault.
I’m pretty excited to see how IROs grow and how participants utilize them. Growing adoption and adding a new alternative to stablecoin protocols that are available today should lead to an instant use-case for Dopex’ stablecoin, DPXUSD.

About Dopex

Dopex is a decentralized options protocol that aims to maximize liquidity, minimize losses for option writers and maximize gains for option buyers — all in a passive manner.
Dopex uses option pools to allow anyone to earn a yield passively. Offering value to both option sellers and buyers by ensuring fair and optimized option prices across all strike prices and expiries. This is thanks to our own innovative and state-of-the-art option pricing model that replicates volatility smiles.

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