Foreword

The crypto options market is still in its early stages of development and has not yet gathered enough liquidity, with a limited variety of underlying assets for trading.

Given the recent downturn in crypto market sentiment, investors may lean towards products that offer relatively stable income. Risk management and hedging have become focal points in the market, presenting potential opportunities for the options market. The emergence of structured products has driven the development of most on-chain option protocols. Compared with complex option formulas, these products lower the entry barrier for users to participate in options trading while providing increased liquidity and higher returns. They are favored by investors in both decentralized exchanges (DEXs) and centralized exchanges (CEXs). Currently, the on-chain options market is dominated by structured products, with limited applications for other types of products.

Power Perpetual is a cutting-edge concept in the derivatives market, requiring users to possess a certain level of expertise. Squeeth, introduced by Opyn, is a pioneering product that has garnered a user base and funds since its launch, potentially marking a new venture in the options market. This article provides an overview of the development of the Opyn project and explains how its core product, Squeeth, works in detail.

Opyn Overview

Opyn is a decentralized options protocol that operates using an order book model for trading. Opyn V1 was released in 2019 and initially focused on insurance. At the end of 2020, the team launched V2, which implemented options trading on 0x. V2 employs European, cash-settled options and automatically settles the price difference through smart contracts upon expiration, directly paying the buyer or seller. The options minted by Opyn V2, called oTokens, are essentially ERC-20 tokens that can be traded on DEXs.

Due to a lack of liquidity and high Ethereum transaction fees, the protocol did not experience a significant surge in trading volume and user numbers after the launch of V2. However, with the introduction of structured products by Ribbon Finance, which relies on Opyn’s infrastructure for options settlement, Opyn’s trading volume and Total Value Locked (TVL) have witnessed significant growth. Since its launch, the Opyn ecosystem has been growing steadily, and the team has launched a series of development tools and templates to provide resources for developers. Currently, Opyn V2 has become the infrastructure used by many other protocols to mint oTokens and build structured products.

Opyn secured an investment led by Paradigm. Since Paradigm proposed everlasting options and perpetual futures, the Opyn team has been continuously researching its products for over half a year and subsequently launched its core product, Squeeth. Currently, Squeeth is undergoing continuous improvements. In the following section, we will dive deeper into Squeeth.

Power Perpetual

The essence of derivative products in the current market is to achieve a mapping between the underlying asset price and the derivative price. One type of derivative product has a linear relationship with the spot price, such as perpetual futures. Another type exhibits a nonlinear relationship with the spot price, where the derivative price increases more significantly when the spot price rises, but decreases to a lesser extent when the spot price falls. This phenomenon can be described as convexity in mathematics. Options, due to the asymmetry between returns and risks, have a nonlinear payoff structure. Based on this feature, Paradigm introduced a new type of derivative called power perpetual in August 2021, which eliminates the need for both strikes and expiries while also possessing convexity by simulating the risk exposure of options.

Similar to perpetual futures, power perpetuals also have a mark price and an index price, where the mark price is the trading price of the power perpetual, while the index price is the spot asset price raised to the power of N. Similarly, the longs in power perpetuals are required to pay funding fees to maintain their positions. Scholars have derived a general pricing formula for power perpetuals by incorporating various differential equations based on the Black-Scholes model:

(where S is the spot price; p is the power; r is the risk-free rate; f is the funding period in years; v is the annualized volatility)

What is Squeeth?

In early 2022, the Opyn team launched Squeeth (squared ETH) based on the power perpetual derivative proposed by Paradigm. Essentially, Squeeth is a special form of a power perpetual with ETH as the underlying asset when n=2. The oSQTH, the Squeeth ERC-20 token, offers leverage and has no expiries, which tracks the value of ETH^2. Users can buy and sell oSQTH on Unsiwap V3. To buy oSQTH, you open a long position, while to sell, you open a short position.

To long Squeeth, users buy oSQTH and obtain a leveraged long position. As it tracks the value of ETH^2, when the price of ETH doubles, the price of Squeeth will quadruple. This demonstrates that long Squeeth provides positive convexity, which is referred to as positive gamma in the language of options. It means that compared to a 2x leverage, long Squeeth allows for higher profits when the price of ETH rises and lowers losses when the price of ETH falls. Therefore, long Squeeth offers unlimited upside in ETH^2 returns and protected downside. Benefiting from the positive convexity, long Squeeth holders pay funding fees to the shorts.

Short Squeeth means that users sell oSQTH and take a short position on ETH^2. To do this, they need to collateralize a certain amount of ETH. The profits for the short position come from earning the funding fees paid by the long positions on a regular basis.

Source: /medium.com/opyn/squeeth-primer-a-guide-to-understanding-opyns-implementation-of-squeeth-a0f5e8b95684

How Squeeth Works

Users can use Squeeth to long or short ETH^2 via Uniswap V3.

To short Squeeth, users need first to collateralize a certain amount of ETH to the smart contract to mint oSQTH, with a collateralization ratio of 200%. The protocol sets a minimum collateral requirement for opening a short position, which currently stands at 6.9 ETH. Once oSQTH is minted, users can sell it in the Uniswap V3 pool to assume a short position. To close the position, you must buy back oSQTH from the market and burn them to unlock the collateral. The protocol will set up a vault for each order that mints oSQTH. When the collateralization ratio falls below the safe threshold of 150%, liquidation is triggered. Liquidators can get a 10% liquidation reward if they fill up the missing oSQTH in the vault and unlock the corresponding collateral.

To long Squeeth, you can purchase oSQTH from the Uniswap V3 pool and pay a trading fee of 0.3%. Additionally, the longs are required to pay funding fees to the shorts regularly. Since the funding fees are settled in kind, the longs do not face the risk of liquidation.

Source: https://opyn.gitbook.io/squeeth/squeeth/contracts-documentation

Funding Fees

Similar to perpetual futures, the longs need to pay the shorts funding fees on a daily basis. The funding fee is calculated as the position size * (mark price - index price), where the mark price is the trading price of Squeeth and the index price is the square of the spot price of ETH. Squeeth uses the Uniswap v3 GMA (geometric moving average) TWAP of the ETH/USDC pool, with a weighted average period of 420s.

In Squeeth, the longs do not pay the funding fees in cash but in kind. This means that the fees are paid using oSQTH tokens. When the longs pay funding fees, the value of their oSQTH holdings decreases. Similarly, when the shorts receive oSQTH, the amount of oSQTH debt they need to repay for redeeming the collateral (ETH) is reduced.

In order to reduce on-chain transaction fees, the protocol does not frequently adjust the oSQTH holdings of each individual. Instead, funding fees are paid by changing the exchange rate between oSQTH and ETH. For example, let’s assume the shorts collateralize 1 ETH to mint 100 oSQTH. After one month, if the funding rate, calculated based on the mark price and index price, is 10%, Squeeth will automatically reduce the shorts’ required redemption of oSQTH from 100 to 90. According to the project team, the variable (10% in this case) that adjusts the amount of debt owed for short positions is referred to as the normalization factor.

The normalization factor reflects the funding rates of long and short positions. Users can calculate the funding fees they need to pay or receive for holding an ETH^2 position based on the changes in the normalization factor between two points in time. Additionally, the normalization factor also reflects the relative price of oSQTH as ETH^2 changes, and the price of oSQTH reflects the value of funding fees accrued. Therefore, the price of oSQTH can also be calculated based on the current normalization factor. The price of Squeeth is derived from oSQTH and the normalization factor (denominated in USDC). The team adjusted for the impact of the normalization factor and scaled by 10,000 to avoid excessive fluctuations in the oSQTH price. The calculation formula is as follows:

Suppose the normalization factor of a long position is 0.9, the average price of ETH/USD in one month is 3,000 USDT, and the price of oSQTH is 835.24 USDT. Using the normalization factor, we can calculate the Squeeth price as follows: Squeeth Price = 10,000 835.24 / 0.9 = 9,280,444.44 USDT. The percentage change of the normalization factor is calculated as (9,280,444.44 - 3,000^2) / 3,000^2 = 0.0307. The new normalization factor is 0.9 (1 - 0.0307) = 0.872.

The in-kind payment is similar to the cToken interest calculation method in the Compound protocol. Its advantage is that there is no need for frequent on-chain transactions, and there is no liquidation risk for long positions. The impact of funding fees will be reflected in the price of oSQTH. Therefore, in the long run, the price of oSQTH will deviate from that of ETH^2, but the price of Squeeth will remain close to that of ETH^2. As shown in the figure below, the value of oSQTH held by longs will slowly decrease relative to the index price ETH^2, resulting in a widening deviation between the two. On the other hand, the amount of debt owed for short positions will gradually decrease over time.

Source: https://medium.com/opyn/squeeth-primer-a-guide-to-understanding-opyns-implementation-of-squeeth-a0f5e8b95684

How are Returns Calculated for Long and Short Squeeth Positions

Squeeth is a contract that tracks the square of the ETH price, and its profits are calculated as y=x^2. When the ETH price changes by a, the Squeeth price changes accordingly to (ETH + a)^2, and a funding fee must be paid during the holding period of a long position. Therefore, the returns for a long position can be calculated using the following formula:

For a short position, its returns are originally opposite to that of a long position. However, since on-chain short positions require collateral in the form of ETH, the fluctuation in the ETH price is also part of the returns of short positions. Considering an ETH collateral ratio of 200%, the net returns for a short position can be calculated using the following formula:

Assuming that the current daily return rate of ETH is 5%, without considering funding fees, the return rate for long positions would be 5%^2 + 2 * 5% = 10.25%, and the return rate for short positions would be -5%^2 = -0.25%.

From the above discussion, it is evident that the returns and risks for short and long positions in Squeeth are not symmetric. The additional funding fees serve as a mechanism for transferring risks. For long positions, as the ETH price rises, they can earn more profits, but they are required to pay funding fees continuously. Therefore, there is a risk of their oSQTH holdings gradually decreasing and approaching zero. On the other hand, short position holders benefit from continuously earning funding fees. However, if the ETH price keeps rising, the losses for short positions can be infinite, and there is a liquidation risk. Therefore, in theory, the overall design of Squeeth tends to favor long positions. However, for professional investors, strategically opening short positions at appropriate prices to consistently earn funding costs can be advantageous.

Source: https://www.opyn.co/squeeth?ct=RU

Vault – Yield Product Based on the Implementation of Squeeth

The Opyn team has also introduced vaults for Squeeth, which enable automated yield strategies in different market conditions. These include the Zen Bull strategy, the Bear strategy, and the Crab strategy. Users can earn yields by depositing supported assets into the corresponding vault. Currently, the Crab and Zen Bull strategies are live. However, as the Zen Bull vault has integrated the Eular Finance protocol and is affected by the Euler attack, it has been temporarily suspended.

The Crab strategy involves holding USDC and short Squeeth positions to maintain a portfolio where the Delta is approximately 0. Users can participate in this strategy by depositing USDC into the Crab vault. The vault will send the deposited USDC to the collateral contract to mint oSQTH, which is then sold on Uniswap to acquire ETH. Selling oSQTH effectively represents holding a short position in Squeeth. Therefore, the investment portfolio consists of holding ETH and a short Squeeth position.

The strategy achieves an approximate delta of 0 after each hedge by regularly rebalancing the ETH and short Squeeth positions. When the ETH price rises, the delta becomes negative, prompting the vault to buy oSQTH. Conversely, when the ETH price falls, the delta becomes positive, leading the vault to sell oSQTH. Essentially, the strategy adjusts the ETH and short Squeeth positions to maintain a near-zero delta. The vault performs three rebalances per week.

From the yield curve, we can see that when ETH fluctuates in a small range, the profit and loss of the long ETH position and the short Squeeth position nearly cancel each other out. When the ETH price remains unchanged, this strategy can maximize profits, making it suitable for market conditions where ETH exhibits minimal changes. As long as the daily price fluctuations of ETH are smaller than the implied volatility, the strategy can generate profits. However, in the event of significant ETH price fluctuations, if the collateral value falls below the safe collateralization threshold of 150%, the strategy is at risk of liquidation.

Source: https://opyn.gitbook.io/opyn-strategies/opyn-strategies/crab-usdc/under-the-claws-technical

The Zen Bull vault integrates the Eular protocol. Users deposit ETH into the vault and the smart contract will automatically allocate 50% of the deposited ETH to the Eular protocol to borrow 2x leveraged ETH, and the remaining 50% is allocated to the Crab strategy vault. This strategy is suitable for market conditions where ETH is continuously rising. However, the Zen Bull Vault is currently suspended.

Latest Developments

Since the launch of Opyn V2 in 2020, it has had low liquidity until Ribbon Finance built structured products on top of it. Following that, the total value locked (TVL) and liquidity increased significantly. And the introduction of Squeeth and the Crab Strategy also attracted additional users and funds, while token airdrops in the market incentivized user deposits and further increased the TVL, surpassing $300 million in April this year. Although the decline in the entire crypto market sentiment has resulted in a decrease in its TVL, it still remains higher than in 2021. Currently, the TVL stands at around $38 million.

Source: https://defillama.com/protocol/opyn

Since its launch, Squeeth has accumulated significant trading volume and user base. The total trading volume exceeded $530 million, with the peak occurring in May 2022 when the daily trading volume exceeded $5 million.

The cumulative number of users on the platform has reached over 20,000, with the highest daily number of traders reaching 800.

Source: https://dune.com/momir/SQUEETH

Conclusion

Opyn initially launched as an on-chain options trading platform using an order book. However, its liquidity, number of users, and trading volume remained low even after the introduction of Opyn V2. The emergence of Ribbon Finance presented an opportunity for the protocol, which is used as the infrastructure to mint options tokens, thereby creating structured derivatives. Currently, Opyn V2 serves as a foundational protocol for options products, leveraging DeFi composability to hedge risks. Its primary target audience comprises institutions, developers, and other DeFi protocols rather than retail traders.

The launch of Squeeth has reshaped the protocol’s development direction, catering specifically to retail traders. The team also provides strategy vaults to hedge against short-side risks in different market conditions. This has lowered the entry barrier for users but may not meet all the requirements of professional investors. Additionally, users can construct combinations of futures and Squeeth to fully hedge impermanent loss risks on Uniswap V3, which could potentially expand future trading markets.

Power perpetuals are a cutting-edge concept in the derivatives market, providing users with positive income convexity. Compared to other options products, they impose a less on-chain computational burden. Since its launch, Squeeth has created a new derivatives market and accumulated a certain amount of user base and funds, enjoying a first-mover advantage. This serves as a new attempt in the derivatives market.