DYMMAX (Dynamic market making auctions and exchange) is a decentralized protocol for issuing options for cryptocurrencies based on the parimutuel betting with fixed odds pricing model with possible secondary circulation of issued contracts in the form of ERC20 tokens.
The DYMMAX protocol was created to solve the following problems of the decentralized derivatives market:
- 100% contract security;
- high premiums;
- low liquidity.
The problem of full collateral for decentralized options arises due to the absence of a single settlement center that controls traders’ profits and losses. For this reason, in addition to the premium, the buyer of the option is obliged to contribute to the contract the amount corresponding to the strike price for the quoted asset, and the seller is obliged to contribute the underlying asset itself. As a result of this operation, before the option is exercised, more than 200% of the value of the underlying asset remains blocked in the smart contract at the time of the conclusion of the contract for the ATM strike.
If we use barrier options to solve this problem, then the buyer and the seller contribute amounts that make up the difference between the strike price and the barrier. Of course, the contract in the case described above is calculated, not deliverable. But such contracts are dangerous because the price may get above the barrier for a short period of time and the option will be exercised. Such a price change may be caused by the price data provider or the oracle in the smart contract. For this reason, such contracts only reduce the amount of blocked funds, adding new equally serious problems.
The problem of high premiums partly comes from the need of fully collateralized contracts. But to a greater extent it stems from the inability of the option seller to hedge risks by the underlying asset or other instrument with constant correlation to the underlying asset. Despite the fact that cryptocurrencies are a highly volatile instrument, and high premiums correspond to the risk that the seller accepts based on the Black-Scholes pricing model, the main adjustment in this is made by the seller’s inability to cover his risk if the underlying asset moves in the opposite direction from the position. Thus, sellers try to protect themselves in case the price moves and inflate premiums, which in turn discourages buyers from making a deal.
The problem of low liquidity of decentralized options is a combination of the two problems discussed above. Many traders choose to trade derivatives on centralized exchanges, financially benefiting from high return on equity through low collateral. At the same time, the risks of a single regulatory center fall into the background in comparison with the benefits obtained.
When looking for a solution to the problems described above, we also tried to provide traders with the following advantages over the spot market:
- the ability to hedge low collateral positions;
- increased profitability of speculative transactions.
How DYMMAX Protocol Works
The protocol is based on the parimutuel betting with fixed odds, which includes a developed matching algorithm for orders received during the auction. The option issuing mechanism is fundamentally different from the classic exchange model, where each option contract contains a market maker which quotes the contract with a certain spread from the expected calculated volatility(IV). Instead of the usual market maker, we developed a system with an automatically prolonging 24 hour auction.
Despite the novelty of the described algorithm, traders receive undeniable advantages when using the auction:
- No slippage when making a deal;
- No spread when entering the market;
- All participants receive options at the same and better prices;
- All participants receive contracts with an ATM strike, regardless of the moment of submission of the application.
After the end of the auction prior to the execution date, all contacts are freely traded in the form of ERC20 tokens, which can be done using the DYMMAX decentralized secondary circulation platform.
Payments at the execution date are made from the money pool, which is put in the smart contract. The pricing model underlying the protocol is self-funded, which means that payments on all winning options are guaranteed by the money pool in the smart contract and do not require external intervention.
The DYMMAX protocol has the following advantages:
- Leverage up to 20:1;
- Limited risk when the market moves in the opposite direction;
- The ability to profit from falling and stagnating markets;
- Long-term portfolio insurance;
- Risk management for market makers;
- Tokenization of issued options;
- Instant profit-taking in the secondary market.
Given the complexities of implementing common financial instruments using decentralized protocols, some of them will need to be drastically changed to match the original idea of cryptocurrencies. This is exactly the adaptation that the DYMMAX team dedicated themselves to during the development of the decentralized options protocol.
In the next articles:
- Option strategies based on an innovative protocol;
- Review of the beta version of the DYMMAX platform;
- How to increase profits using option strategies;
- Trading options in a volatile market.