Crypto structured products come of age

For the traditional asset management client base, structured products have long ruled. The powerful autocallable stock, in particular, has long been a favorite among investors, providing them with a cushion of downside protection combined with upside exposure to individual stocks or baskets.

Over the past year, however, the crypto industry has been quietly working on its own versions of structured products that are becoming more and more sophisticated as the months go by.

These have largely existed in a corner of the crypto landscape known as decentralized finance (DeFi) – that is, unconnected to any centralized exchange such as Binance or FTX. Instead, the investor uses smart contracts to execute the investment strategy on their behalf.

While a centralized platform may block users from using derivatives depending on the jurisdiction’s regulatory status – for example, Great Britain retail users cannot trade crypto futures on most large, centralized venues – DeFi has no such restrictions. That means users can access sophisticated derivatives strategies that would otherwise be out of their reach – for better or for worse.

The original crypto-structured products were placed in so-called DeFi alternative vaults (DEAFs). Users deposit crypto anonymously in DEAFs – whether it is stablecoins such as tether or USDCor assets such as ethereum (ETH) or bitcoin – and DEAFs go out and execute an investment strategy on behalf of the investors.

The original DEAFs ran simple covered call or set sales strategies. The first and largest protocol offering DEAFs is Ribbon Finance, with $78 million in its DEAFNov. 4, according to aggregator site DefiLlama, down from a peak of more than $300 million in May — before the start of the so-called crypto winter. Other major protocols include Thetanuts and StakeDAO, which also offer similar products.

The ETH covered call DEAF on Ribbon takes deposits ETH and sell out of the money one week ETH calls on 10 deltas to earn the prize, which is around 0.25-0.45% a week. If the options finish in the money, the premium is lost and the increase in the underlying ETH assets are effectively limited. Investors are still exposed to the underlying ETH however, loses value.

The put sale vaults usually see the user deposit stablecoins into DEAF, which sells downside plasters and collects a prize. These are slightly more risky, as there is no natural offset if the cushions expire in the money.

The options are sold via auction at 09.00 UTC on a Friday. However, since the size and timing of options sales are well known in advance, market makers can predict the flow. Implied Volatility on Weekly ETH options around auction time are typically about four vols in the previous 24 hours, according to research from Paradigm.

According to their research, that equates to around 0.1% less in premiums, or 5.35% annually in lost winnings. Market makers who buy the options, however, say they need to position themselves for these flows, which some say are responsible for about a quarter of the entire supply of crypto options volatility and run into billions of dollars of ideas every week at some market makers.

This raised questions as to whether DEAFs was a victim of its own success and led some to wonder if further expansion was possible. Ribbon, for example, was looking at running more random, unannounced auctions a week, but this raised concerns among market makers that they would not be able to handle the flow without sufficient notice. In its research note, Paradigm suggests pre-announcing but spreading the auctions to mitigate the impact on implied volatility.

But despite these growing pains, the firms have not been put out and have instead sought to create newer, more sophisticated strategies.

Ribbon launched a principal protected product in August, which provides returns from lending USDC deposits to market makers such as Genesis and Wintermute and uses part of the interest payments to buy weekly out-of-the-money barrier options at around 8% on the upside and downside. It offers a base return of 4% with the potential for returns of up to 13% depending on whether the options end in the money.

The question now is where crypto-structured products can go next. Those in the know say the end game for firms like Ribbon is to offer the full range of private banking products, including autocallables.

Some suggest they could be a disruption to the TradFi private banking market, but with a broader base given the lack of a minimum asset requirement to invest. However, after the problems with crypto earlier this year, the assets under management of the likes of Ribbon took a hit and have remained fairly stable since.

On the institutional side, many firms are positive in this area. In the past year, a number of them have emerged to serve institutional clients looking for crypto-structured investments without necessarily wanting to dive into DeFi themselves or needing bespoke structuring solutions. These firms include OrBit Markets and Enhanced Digital Group, which were founded by former derivatives traders at major sell-side banks.

If institutional investors rediscover the interest in the space they showed before the crypto winter set in, who knows where it could lead?