Crypto and derivatives are a match made in heaven; their bond is unbreakable and financial instruments that offer exposure to an underlying asset, such as a commodity like gold or cryptocurrency like bitcoin etc.
The value of derivatives is tied to that of the underlying asset, crypto traders speculate derivatives to take advantage of the price actions of various cryptocurrencies. Options and futures are examples of derivatives, although futures are currently winning the popularity contest.
An option is a financial derivative contract that gives the buyer the right, but not the obligation, to buy or sell a specific asset (in this case, a cryptocurrency) at a predetermined price and date, Options allow traders to manage risk, obtain leverage, Lock in a payoff and construct any payoff structure.
The top 3 options trading protocols by TVL have a combined Total Value Locked of over $96M, with Lyra Finance ranking second with a TVL of $32.18m and a Mcap/TVL of 1.49.
What Is Lyra Finance?
Source: Lyra Finance
Lyra finance is an automated market maker (AMM) that allows traders to buy and sell options on cryptocurrencies( ERC-20 tokens) on the Optimistic, Ethereum and Abriturim blockchains; Lyra Finance will enable traders to buy and sell options that are accurately priced with the first market-based and skew adjusted pricing model against a pool of liquidity.
Lyra Finance quantifies the risks incurred by liquidity providers and actively hedges them, encouraging more liquidity to enter the protocol. The Lyra protocol has two key user groups: Liquidity providers and Options traders.
Liquidity providers (LPs) deposit sUSD (a stablecoin) or USDC into one of the asset-specific Lyra Market Maker Vaults (MMVs). This liquidity is used to buy and sell option markets for the asset that the vault specifies. LPs deposit liquidity to the vault to earn the fees paid when options are traded.
Traders use Lyra to trade options. They can either buy options from or sell options to the MMV. Traders pay fees in the form of the bid-ask spread to LPs as compensation for their liquidity.
Lyra finance was launched on the Optimistic Ethereum mainnet in August 2021 with a driving philosophy to reduce risk, especially for liquidity providers, some of the challenges/risks LPs face include impermanent loss and some existing options AMMs often aren’t able to purchase options meaning that LPs are naked short volatility this is extremely risky and competitively priced options protocol without native hedging runs a high risk of LPs losing all of their money over time.
This impermanent loss and high risk are unattractive for Liquidity Providers leading to low liquidity.
Existing protocols with some liquidity offer incredibly high prices to avoid the complexities of the options pricing problem. These uncompetitive prices result in little trading volume all of which lead to unfulfilled potential in the Defi Option space.
How does Lyra Finance hope to overcome these challenges?
Lyra Finance uses market demand and supply to create an implied volatility surface for each expiry, which is then inputted into the Black Scholes pricing model to determine prices for all listed options. This approach results in efficient pricing for traders and consistent returns for LPs.
Lyra’s automated market maker (AMM) actively hedges the delta risk for LPs by using DeFi spot markets to trade the underlying asset. The protocol also quantifies Vega (volatility) risk and incorporates it into its fee structure, incentivizing risk-reducing trades. These innovations enhance the alpha and Sharpe ratio of the AMM, creating a virtuous cycle where increased alpha leads to more liquidity, volume, and fees for the protocol.
Source: Lyra Finance
To manage the delta risk of its LPs, Lyra employs Synthetix as a hedging mechanism. When trades are executed on Lyra, LPs are exposed to the underlying asset. To safeguard their positions, the protocol automatically enters into long/short parts on the underlying asset through Synthetix.
By building on the shoulders of leading protocols in DeFi, Lyra Finance will offer users an authentic trading experience that conquers the challenges of competitors, positioning Lyra as a leader in the ecosystem.
To dive deep into Lyra Finance, we must get accustomed to some of the terms used in the protocol and options trading, for example.
Call: The right to buy the underlying asset, Call options give traders a choice to buy a purchase on a specific date.
Put: The right to sell the underlying asset; put options allow them to sell a purchase on a specific date.
Premium: The cost of an option is usually referred to as a premium.
Expiry: This is the date the call or puts options contract expires.
Strike price: This refers to the price at which the contract buyer has the right to buy or sell the underlying asset upon expiry
How Lyra Finance Works
First, we shall look at their options pricing and AMM, followed by how their Liquidity pool operates, and then Trading.
Options Pricing & The AMM
At its core, options market making involves determining the market value of implied volatility (IV), which represents the expected volatility of the underlying asset between now and expiration. Higher (lower) IV results in an increase (decrease) in the cost of buying (selling) an option.
The Lyra AMM employs a core mechanism to manage implied volatility, raising it (and consequently the cost of the option) when demand is high and lowering it when supply is high. This approach allows the AMM to converge to a market-clearing value for IV for each strike and expiry.
Let’s delve into more detail about how IV impacts option pricing, how IV varies across strikes and expiries, and how the AMM manages risks associated with options trading on Lyra Finance.
The Black-Scholes model is the foundation of options pricing, taking into account five inputs: asset price (S), the strike price (K), risk-free interest rate (r), time to expiry (T), and implied volatility (σ). Using these inputs, the model outputs the price of an option. Notably, four of these inputs are widely known to all market participants: the current price of the asset, the strike/expiry of the options contract, and the risk-free rate. However, implied volatility is the only input that is not observable, meaning that options traders are essentially trading implied volatility. To address this, an option’s AMM must converge to a market-clearing value for IV, which is the approach Lyra Finance uses.
Lyra Finance AMM uses Black Scholes by quoting options over various strikes and expiries. It generates a market-driven value for implied volatility which varies by expiry and strike.
Lyra Finance fee function is made up of 4 distinct components:
- A flat fee based on the option price
- A flat fee for exchanging costs
- A dynamic fee based on the pool’s vega risk
- A dynamic fee is based on the difference between the expiry’s baseIV and its geometric time-weighted average value (GWAV) and the traded strike’s skew ratio and vega.
The first and second fees are relatively simple and yield the spread that the AMM charges for liquidity.
The third fee is how Lyra Finance manages its options exposure risk. The AMM calculates its net vega exposure relative to the pool size, which they call its vega utilization.
This term is multiplied by a boolean parameter equal to 1 if the trade increases the net vega exposure of the pool and 0 otherwise. This creates an asymmetric spread around the Black Scholes theoretical value of the option, where trades that increase the risk of the pool are disincentivized relative to trades that hedge the pool. Full algorithm detail is in their whitepaper.
How Lyra Finance Liquidity Pool Operates
Source: Lyra Finance
Lyra protocol allows liquidity providers (LPs) to deposit USDC or sUSD into a market maker vault (MMV) and earn trading fees. However, LPs should be aware of the risks involved:
- Options market-making risk: LPs’ capital value will fluctuate depending on the MMV’s options position, which is inverse to that of traders.
- Smart contract risk: As with any new DeFi system, there is a risk associated with smart contracts. Lyra has undergone three independent audits for the Newport contracts, which can be accessed here.
Anytime Entry/Exit Mechanism
Lyra protocol employs an “Anytime Entry/Exit Mechanism”, which enables users to deposit or withdraw their funds into the AMM at any time, subject to a withdrawal fee and a short delay. The process is as follows:
- The user signals their intention to deposit/withdraw funds, which cannot be rescinded.
- A cooldown timer of three days starts.
- A withdrawal fee of 0.3% is charged, which is redistributed to the remaining LPs.
- After the cooldown timer elapses and pending the circuit breakers (see below), the net asset value (NAV) of the pool is calculated using a geometric time-weighted average value (GWAV). The value of each LP token is calculated by dividing the NAV by the number of LP tokens in circulation. The user then receives or burns LP tokens according to the value of their deposited/withdrawn capital.
To protect existing LPs, several deposit/withdrawal circuit breakers have been implemented, including:
- Liquidity circuit breaker: ensures that at least 5% of the pool’s NAV is available as liquid (USD-denominated stablecoin) to trade options.
- Volatility circuit breaker: ensures that the GWAVs of baseline/skew/trading volatilities are reasonably close to their market values.
- Contract adjustment circuit breaker: ensures all LPs receive a fair payout during a contract adjustment period in the event of insolvency.
When any of these circuit breakers fire, all deposits and withdrawals will be blocked until the conditions are rectified. A cooldown timer begins, during which deposits and withdrawals are still blocked. For example, the liquidity circuit breaker has a cooldown timer of three days.
Guardians: a multisig of two core contributors and five council members can manually approve deposits that have been signalled for a sufficient period of time to ensure that prolonged firing of the circuit breaker doesn’t prohibit funds from entering the pool.
Lyra protocol aims to reduce PNL fluctuations for LPs and ensure that returns are driven by implied volatility market making. To achieve this, the protocol maintains a delta-neutral MMV, and the following conditions must be met for a delta hedge to be performed:
- The time threshold since the last delta hedge must have elapsed (e.g. every 12 hours).
- A maximum delta threshold has been met (e.g. 20 ETH delta).
- A keeper bot calls the permissionless hedgeDelta() function.
While the DAO runs keeper bots, any actor can perform this role as it is permissionless.
For example, if Alice signalled to deposit $100,000 USDC on August 1, 2022, and the liquidity circuit breaker fires on August 3 and stops firing on August 5, her deposit will be processed on August 8 after the three-day cooldown has elapsed. On August 4, the pool’s net asset value is computed to be $30,000,000, and there are 29,000,000 LP tokens in circulation, making the value of one LP token $1.03. Alice will receive 96,666.
Trading On Lyra Finance
Source: Lyra Finance
Here are a few features you need to know before trading on Lyra Finance
The AMM in Lyra accepts options that users sell but must be backed by collateral. In the first version of Lyra, all shorts had to be fully collateralized, which was not very efficient in terms of capital. For example, to sell 1 ETH call, one sETH had to be available as collateral. However, users can now partially collateralise their shorts, leading to a significant improvement in capital efficiency.
For instance, selling 1 ETH call would now require only 0.4 ETH as collateral – a considerable improvement from V1. Furthermore, short calls can now be collateralized using either the base asset (ETH, BTC, etc.) or the quote asset (USDC or sUSD). However, short puts can only be collateralized with the quote asset. Users can still fully collateralise their shorts to eliminate the risk of being liquidated. To use partial collateralization, users must deposit a minimum amount of collateral.
Specifically, the minimum amount of collateral required will be given by:
MinStaticCollateral is the minimum amount of collateral required for any partially collateralized short, and users need to maintain this amount to avoid liquidation by a liquidator. ShockVol, a significant, time-dependent static volatility, and SpotShock, a static percentage shock to the spot price, are two factors that may impact the amount of collateral required.
When a user’s collateral falls below the minimum collateral (described above), they are eligible to be liquidated. This occurs via keepers, users who call the liquidation function in an underwater position.
When a user is liquidated, the user is forced to buy back their option in such a way that will (in expectancy) favour the AMM/LPs.The user’s remaining liquidity will then be penalized by a flat percentage. For more detail on Lyra finance liquidation, see Partial Collateralization Parameters.
Lyra Finance enforces trading cutoffs to ensure that the mechanism remains accurate and performant. This has some important implications for traders:
- Traders cannot open positions with the AMM for options with less than 12 hours to expiry.
- Traders cannot open trades with the AMM for options with deltas outside the specified cutoff for a given asset. For example, if the delta cutoff range is set to 10-90, users cannot open positions in options with a delta less than ten or greater than 90.
- Traders will only be able to close existing positions outside of the delta cutoff range OR with less than 12 hours to go using the ForceClose mechanism, which incurs a penalty for doing so.
Tokenomics And Governance
LYRA, the naive token of Lyra finance, was launched in December 2021. The LYRA token is available on Ethereum and Optimism. At the time of writing, it is currently sitting at a market cap of over $49M with a fully diluted valuation of over $155M and trading at $0.155.
LYRA, the native token of Lyra protocol, have three initial use cases:
- Governing the protocol via the election of the Lyra Council.
- Securing the platform as collateral in the Security Module.
- Bootstrapping the network through trading and liquidity incentives.
LYRA has a total and max supply of 1,000,000,000. Here is a breakdown of this supply, 50% (500,000,000 LYRA) to the community, 20% (200,000,000 LYRA) allocated to the LyraDAO, 20% (200,000,000 LYRA) allocated to the core team.
This is enough to ensure long-term incentive alignment whilst allowing the community to own the majority of the project, 10% (100,000,000 LYRA) were sold to private investors. The chart below shows a breakdown of the token distribution.
See here for more details on LYRA token allocation.
Source Lyra Finance
Lyra Governance is a system for governing the Lyra Protocol, and the LYRA token enables it. It is centred around a representative council known as the “Lyra Council”, which enables the community to iterate quickly whilst ensuring that token holders have ultimate control.
The Council is a five-seat representative council elected by the LYRA token holders. This council has the mandate to administer the LEAP framework, which seeks to ensure that changes to the protocol are transparent and well-governed. The Lyra Council sits for four calendar months, after which a new Council is elected. So, all in all, LYRA token holders govern Lyra protocol and do not currently take a cut of the total option premiums paid by traders (revenue).
Lyra Finance is pushing to become a leader in the space of Defi options trading, the protocol trailed 2022 with a total notional volume of over $561m from over 28,000 total trades with 5688 unique traders and a total premium volume of over $16m.
In February 2023 Lyra Finance went live on Arbitrum; in March, premium fees on Lyra Finance tripled within a week. This was huge
They had just recorded their highest premium fee ever since the protocol’s inception.
But this had no impact on LYRA, the native token of Lyra Finance, and it didn’t go unnoticed as events like this expectantly impact the price action of native tokens.
I believe the reason for this can be found in their governance. Remember we said that LYRA token holders govern the protocol and “they do not currently take a cut of the total option premiums paid by traders i.e revenue”.
Lyra Finance does not share fees they collect with token holders, so there is no direct relationship between token price and fees collected. If fees were paid to token holders, the token price would reflect the expected discounted cash flows from fees generated.
I like Lyra Finance’s UI/UX as it is smooth and easy to interact with. By building on the shoulders of leading protocols in Defi from Synthetix to GMX and deploying on Arbitrium, one of the liveliest ecosystems, it is clear that Lyra Finance pushes to provide a genuine trading experience that positions them as the new leaders in the ecosystem by surpassing the challenges faced by competitors, Lyra Finance is working to support more sophisticated positions, combining both spot and options trading, as well as spreads, straddles, strangles, and much more.
All of these power moves, coupled with the backing of investors like Framework Ventures, Parafi Capital and Robot Ventures, clearly indicate that Lyra Finance is aiming to sit on the throne of DeFi Options trading.
[Editor’s Note: This article does not represent financial advice. Please do your research before investing.]
This article is done by our freelance writer Godwin Okhaifo
Featured Image Credit: Chain Debrief