Standard Risk Block System Overview
DeVol innovates with a new methodology for risk that decomposes financial payoffs into a series of small elementary units we call “Standard Risk Blocks” (SRBs), a new financial primitive.
The DeVol protocol is based on a new fundamental way of looking at risk that decomposes financial payoffs into a series of small elementary units we call “Standard Risk Blocks” (SRBs).
What are SRBs? SRBs are “state contingent” payout units. Let’s unpack that! Each SRB is associated with a unique price interval, or range, that has a central strike. At expiration, an SRB pays 1 unit of base currency (e.g. 1 USDC) for every stake purchased in the SRB – but only if the underlying ends up in its SRB-specific price range, and nothing otherwise. At option expiration, there is only one SRB that contains the underlier and ends up paying 1 unit of base currency (e.g. 1 USDC) per stake.
SRBs are a groundbreaking new financial primitive. It is easier to think of them as individual building blocks that can be assembled to synthetically price, trade, and settle any customizable financial payoff, including that of traditional options and futures. The payoff diagram of a traditional option can be replicated via a linear combination of stakes in SRBs.
Every time a new option is initialized, a new SRB system is put in place. That is, the smart contract creates 95 SRBs spanning the entirety of the expected price range for the underlier over the time to expiration, on the basis of market variables such as the spot price of the underlier and implied volatility levels. This expected range covers 99.9% of the distribution for the underlier price, and excludes the small 0.1% distributional tails. All strikes that are displayed on the DeVol’s User Interface are the central strikes of all the SRBs.
For example, for the trading pair BTC/USDC, if spot BTC is 45,000 USDC, and annualized implied volatility is 60%, for 1-day to expiration the SRB system would be initialized as follows (only displaying central strikes):
SRB construction. All amounts are in USDC. In this example, the SRB in the middle is centered around spot value (45,000) and covers a price interval of [44,955 - 45,045]. The next SRB to the right has a central strike of 45,090 and covers a price interval of [45,045 - 45,136]. The process continues to the right (47 SRBs are constructed); the outermost right SRB has a central strike of 49,446 and covers a price interval of [49,396 - 49,495]. Similarly, 47 SRBs are constructed to the left of the middle SRB; the outermost left SRB has a central strike of 40,954 and covers a price interval of [40,913 - 40,995].
Converting traditional options into stakes in SRB. The user interface converts all traditional options into stakes in individual SRBs. In order to synthetically re-create the option payoff, the number of stakes being purchased or sold in each SRB is a function of the difference between the option strike and the central strike of each SRB. In our example, a trader buying 1 ATM call option (i.e. 45,000 strike) is actually buying stakes in all SRBs with a strike that is greater than 45,000. See below for the number of stakes being purchased in each SRB.
This all happens automatically under the hood. From a trader’s perspective, it looks and feels as though you’re buying a traditional option.
SRB stakes are designed to synthetically replicate the call option payoff. As long as SRBs are small enough, this system provides a good approximation of the payoff of a traditional option:
Settlement. All amounts are in USDC. Let’s say BTC ends up at 45,420 at option expiration (in this example, one day later). The trader would receive a payout of 453. This is because 45,420 falls in the price interval [45,408 - 45,499] in the SRB with a central strike of 45,453. The trader bought 453 stakes in this SRB, and each stake pays 1 USDC.
Small discrepancy with traditional options. All amounts are in USDC. Notice in this example that the trader receives 453 with the SRB system vs. 420 with a traditional option. The discrepancy is driven by the fact that any value of the underlier at expiration that falls in the “winning” SRB price interval is approximated by the SRB central strike. Here, this favors the trader to the extent that 45,420 is slightly less than the SRB central strike 45,453. However, if instead BTC would have ended up slightly higher, say 45,480, the trader would only receive 453 vs. 480 with a traditional option.
Distributional tails are excluded. Note that if there is an outlier event, for instance BTC jumps to 60,000, the trader only receives the payoff of the outermost SRB (in this example, on the right), namely 9,446 with the SRB system vs. 15,000 with a traditional option. This is of little practical relevance because by construction the probability of such events is very small, 0.05% in each tail (the SRB covers 3 standard deviations on each side).
Full collateralization. All SRB payment obligations are backed by funds in the liquidity pool as long as the underlier stays in the expected range. Since at expiration only one SRB is liable to pay, the pool must contain the maximum amount owed by the SRB system on account of any single SRB, rather than the sum of all payment obligations of all SRBs. In practice this means that there is full collateralization for all potential option payoffs with funds locked on-chain.
Pricing. At any given moment, each SRB has a price. Prices of all SRBs are normalized and add up to 1. As such, they can also be interpreted as probabilities that the underlier will end up in each given SRB at expiration. SRB prices are initialized to mirror the lognormal distribution of the underlier at the beginning of the trading period, estimated on the basis of the implied volatility of options from most recent expirations on the same underlier. After that, ongoing price discovery happens dynamically through the AMM. Note: When the price of a single SRB changes due to supply and demand, the price of all other SRBs will also change since the entire price structure reflects the current distribution at any point in time.
All options are priced on the basis of all corresponding underlying SRB stakes. This is the cost of all stakes being purchased, less the cost of all stakes being sold, as applicable. For any order, the starting point is the current SRB price structure that reflects the distribution. In addition, the AMM price impact function evaluates the expected change in liquidity and inventory risk after each trade based on the size of the incoming trade relative to available liquidity, and the trade’s contribution to the overall pool risk profile given all prior trades in the expiration. The price impact function will apply two separate price impacts:
(1) An adjustment due to the impact of the trade on liquidity (mark impact).
(2) An adjustment due to the contribution of the trade to total inventory risk given all prior existing positions in the pool (risk price impact).
After the trade, pricing is adjusted to reflect the mark impact. The risk price impact is collected by the pool, but does not affect the overall SRB pricing after the trade.
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