Retailer — Settlement Guarantee Protocol — SGP

Introduction

The retailers contribute to the anti-fragility of the system while being able to mutually benefit. Smart Options provide a critical investment mechanism currently lacking in the cryptocurrency ecosystem, the ability to take leveraged long or short positions on decentralized exchanges.

Calls are tokens that get generated dynamically by the issuer. A options holder can purchase call option tokens (COT) from the issuer, which specifies a strike price. The strike price is the exchange rate for Token/ETH.

The COT holds no collateral. After it expires (e.g. 3 months) the owner of the option has the right to exchange the token with the underlying asset (ETH) at the predetermined strike price. Since the option is a call the exerciser gets 100 tokens for 1 ETH, a good deal since the typical market price is usually 70 tokens for 1 ETH and the exerciser only spent 0.1 ETH on the premium (the price he pays when he purchased the option).

Now the issuer only deposits 20% of the tokens, in this case 100 * 0.2 = 20 Tokens. How does the issuer allocate 100 tokens for the options buyer? A large reserve of these Tokens are funded by liquidity providers who can be individual entities or decentralized exchanges. In the context of derivatives, they function as a clearinghouse.

At time of exercise, the exerciser sees the issuer doesn’t have enough, it automatically proceeds to deal with the reserve. Exerciser gives the reserve 1 ETH and gets 100 tokens. The reserve balance will be very high. Since the fair market rate is 1 ETH for 70 tokens, the reserve posts a loss of .3 ETH (30 tokens). The reserve gets compensated with the issuer’s collateral (20 tokens).

Now account for premium of 0.1 paid out to the Issuer. Since that ETH is not locked up, the issuer actually turned that ETH into another 10 Tokens that were sent into the collateral deposit, and issued an options contract set to expire a few days after the first COT expires.

Case A:

• No one buys that contract, so the reserve reclaims the call option token (COT) as well as the 10 token collateral needed. The original issuer is now square.

Case B:

• The contract was bought this time for a higher premium of 0.15 ETH. After the first option is exercised but before the second, the option buyer sees that the option is deep in the money (profitable).
• Let’s say that option is the right to buy 50 tokens for 0.33 ETH. At this point assume fair market rate is 70 tokens for 1 ETH.
• So this option has the tokens 2.14x the market rate. (.5/.3) / (.7/10) = 2.14
• Very likely assuming exerciser acts in economic self interest
• Reserve dispatches a margin call, the issuer has two choices.
• Issuer balance: 0 Tokens, 0.15 ETH. Profits from selling the second COT
• The issuer must pay 0.1 ETH and then an additional .5 ETH (penalty fine) for defaulting
• Ceiling for penalty fee is the implied value of exercising the outstanding call option. Given the obligatory exchange rate of 50 tokens for .33 ETH, subtracting the market rate would get you 23.33 tokens, then the difference is a profit of 50–23.33 = 26.67 = .26 ETH. So up to .26 ETH could be taken from the issuer’s account.
• The issuer is also responsible for offsetting subsequent losses following the same process above.
• If the issuer fails to pay up his debts or his margin call, their accounts are disabled and are no longer able to issue more options.

Decentral’s foundation automatically compensates the reserve for any losses of this nature in tokens.

4.2.2 Put Options Contracts

Case C:

• The contract is actually a put option token (POT), since most issuers become issuers because they want to hedge rather than speculating.
• They actually issue this soon thereafter they receive the premium from selling the COT.
• Since they created the put option, it’s unlikely that anyone buys it because the general trend is that this token value.
• Issuer gets margin called, and forfeits the collateral for the POT and the POT is destroyed.2

Case D:

• Assuming that the issuer had the opposite position with a COT…
• If the PUT option is sold, it’s unlikely to get executed as it’s not economically feasible for the POT owner to exercise it.
• Issuer gives reserve the premium from the put option settles it.

Issuer

The issuer needs to meet the reserve requirements and are voted to be approved by the Ondecentral governance team.

Thus issuers can adjust their hedging strategy in real time.

4.3 Clearinghouse — Near-Instant Settlement Protocol

4.3.1 Introduction

The role of the clearinghouse in a traditional financial market is to serve as a trusted 3rd party between exchanges and the retail users that trade on the exchange. Pairing’s Near-Instant Settlement method allows for the creation of Decentralized Clearinghouses which operate as DAOs. The DCH ensures all option contracts ultimately settle at the predefined rate between the option buyer and seller.

4.3.2 Clearinghouses

Issuers typically make high yield margins from selling their options for premiums. Our protocol is built to make it as easy as possible for any business to build integrations with our protocol. Yet beyond all else we must pay option buyers in full, even when exercising a smart option defaults the issuer. We achieve this with the Near-Instant Settlement Protocol (NSP) defined below.

High Level Logic.

1. Exerciser chooses to exercise a put option of ETH/USD
2. Clearinghouse gives the USD to the exerciser while taking in ETH
3. Options nets a profit of 100 ONA (which has the buying power of $100) post exercise.
4. After the transaction, the clearinghouse smart contract knows the amount of money it’s owed, which is $100 ONA
5. It makes a query to the Issuer, and extracts 100 ONA from him
6. Issuer pays Clearinghouse in full.

Initially our investment arm will be the first decentralized clearinghouse, as we grow we allow anyone to onboard themselves as a clearinghouse.

Let’s define total equity of account be the total asset value across all options in a given margin account.

Let’s define margin maintenance as the minimum amount of equity that must be maintained in a margin account. As options are issued on margin, the minimum required level of margin is 20% of the total equity of account.

Let’s define t_e as time to expiration.

Case 1: Option buyer makes money. Option seller loses money.

1. Issue an ETH/USD put option, assumes it’s now in the money, a liability to the issuer.
2. Option total duration is 30 days, since it was issued 20 days ago, t_e is now 10 days.
3. Issuer’s in the money net loss is 60 ONA (or $60)
4. The Clearinghouse smart contracts detects that this loss of 60 ONA puts the Issuer under the red-zone, where they may be margin called
5. The DCH has access to the Issuer’s collateral account under these conditions
6. Issuer has been in red-zone for more than 24 hours
7. Issuer has not deposited more collateral such that they are above margin maintenance
8. The DCH thus automatically repossess Issuer’s collateral and disables trading until all balances are settled.
9. First phase they are required to KYC

The outcome in which option seller nets profit is more common. Typically, option sellers come from quant trading backgrounds. They’ve been trained by institutions to consistently recover positions using option hedging strategies.

Core critics will say that this model relies on price-feeds for BTC, ETH, ERC20 tokens, that serve as a fully reliable Oracle. Luckily for us, we have this as a byproduct of the Option Issuance Protocol.

Case 2: Option buyer loses money. Option seller makes money.

1. Issuer has sold an ETH/USD put option for premium p, that is now in the money, which puts the issuer at a loss
2. This option was issued 20 days ago, time to expiration is 10 days
3. Issuer’s in the money net loss is 60 ONA
4. The Clearinghouse smart contracts detects that this loss of 60 ONA, however the Issuer tops up his margin account with an additional 70 ONA within the 24 hour timeframe
5. The price movement of the underlying asset reverses, thereby putting option back out of the money.
6. The Issued option never gets exercised, and the Issuer’s posts a net gain of p

Now you may ask, how does this stablecoin work? This stablecoin is needed to make the option system work. What fuels the value? Liquidity. In this ecosystem as Issuers get margin called they are forced to deposit the collateral in the base underlying asset. For an ETH/USD call option the underlying asset is ETH. Since at the end of the day, someone needs to fork up the promised amount of ETH in the contract. For an ETH/USD put option, that would be ONA.

Every time an Issuer exchanges ETH for ONA to maintain his margin, he pays a small fee in ONC. That fee is collected by the Clearinghouse to generate income for reserve managers of the Decentralized Clearinghouse.

Every time a Retail investor exercises any option, they pay a fee that’s a percentage of the total underlying asset. So in a call, ETH is rewarded, the fee is paid as ETH. In a put, ONA is rewarded and the fee will be in ONA.

Why ONA? Because when the exerciser receives ONA, they can hold it (as a safe stablecoin to keep) or sell it for ETH on ours or any decentralized exchange. The reserve manager again makes commission from that liquidity acting as a market maker. Continued in our next blog post outlines the Near-Instant Settlement Protocol we implement for how we’ll create this stability mechanism.