Introducing Predy — the First-Ever Portfolio Margin Solution That Hedges against Impermanent Losses
Imagine a derivatives AMM that lets you earn steady Annual Percentage Yield (APY) by automatically hedging Liquidity Providers (LPs) against impermanent losses, and that lets users trade power perpetuals through an easy-to-use, intuitive UI.
Well, after a few setbacks, Predy Finance has finally achieved just that.
Predy V1 — Learning from our mistakes
We released Predy Finance as an options trading Automatic Market Market (AMM) on Layer 1. We managed to get in some LPs, and saw that our AMM worked in concept — we had achieved a concentrated liquidity as per an option’s implied volatility range.
For those not au fait with concentrated liquidity — it is a Uniswap feature that lets LPs allocate liquidity only within a specified range. For Predy V1, we let LPs allocate liquidity as per the implied volatility ranges they chose.
The other concept we proved was that it was possible to achieve delta hedging on AMM.
Unfortunately, V1 didn’t attract as many active users as we had hoped.
We realized that, even though we were more competitively priced, we needed a better overall value proposition. This took us back to the drawing board of cryptocurrency derivative trading to find out what users really wanted in this area.
Existing issues with on-chain options trading
Opyn, Hegic, and Lyra were already providing various solutions for on-chain options trading.
Each of these solutions was successful to some degree, but none stood out strikingly from the rest. They were doing what we had also been doing — trying to offer what a Centralized Exchange (CEX) like Deribit was offering, but in dApps.
Our thinking here is that dApps should not try to mimic CEXes if they wish to be better than them. dApps are relatively newer technology than traditional, centralized on-chain solutions and so reinventing the wheel is pointless. For a dApp to outperform a CEX in its features, it must do things better. In DeFi, that means leveraging the unique features of DeFi that CEXes don’t have access to.
The hard pill for us to swallow was that a CEX will always do traditional options trading better because of factors which are just not suited to on-chain parameters — namely, maturity dates and strike prices.
Also, we felt that the computational cost for pricing options using the Black-Scholes-Merton (BSM) model was too high for an on-chain solution. Simply copying CEX functionality into a dApp would bring no great benefit to users because:
- The computational cost of BSM is enormous.
- Gas fees for transactions with a maturity date and strike price are huge.
Cutting the maturity date — the Everlasting Options paper
That was when DeFi leader Paradigm released the Everlasting Options paper on May 11, 2021, a watershed moment for DeFi options trading.
Everlasting options are to options what perpetuals are to futures — the ability to open up a DeFi options position without a maturity date, allowing options traders to hold an option endlessly. Because a trader does not need to constantly open and close positions just to keep holding them, they save on spreads and risks.
This breakthrough soon gave rise to power perpetuals, an “options-like exposure without the need for either strikes or expiries.”
Power perpetuals let you cash in on an underlying asset to the power of the perpetual you took out. So, if ETH doubles, Your ETH² power perpetual would increase by four. Your ETH³ would increase by eight, and so on. “Those who are long a power perpetual must regularly pay a premium yield to those who are short it,” said the paper.
When a power perpetual is taken out on ETH (i.e., ETH²) it is called a squeeth.
In essence, power perpetuals have constant gamma. In layman’s terms, that means that, when the underlying asset gains, then you gain big, but when the underlying asset loses, you lose commensurately less than if you had simply taken out a 2X leveraged ETH position.
The reason Squeeth is superior to the CEX BSM model is that it performs like an option (even though it is not really an option in the strictest sense) but uses Token Swaps instead of on-chain maturity dates and strike prices. This brings the computational cost right down and raises the value of the dApp solution immensely from a user’s perspective.
The Predy Approach: Portfolio Margin on DeFi
After considering all the factors, we decided to build on Paradigm’s research.
Our goal was to increase capital efficiency and address unexpected settlement issues by implementing Portfolio Margin as a DeFi solution.
Look at the App UI!
Predy offers trades with USDC as collateral.
Portfolio Margin is a composite-margin policy that is required for certain types of derivative trading in traditional financial markets. Portfolio margin offsets overall risk by calculating margin based on the entire portfolio as opposed to on a single trade.
The importance of Portfolio Margin versus other margin types
The best way to understand the impact of using a portfolio margin approach in options trading is to compare it to the other two models currently in use:
- Isolated margin and
- Cross margin
In Isolated Margins, each margin is assigned to a single position only. If the margin falls below the Maintenance Margin level — the minimum collateral the user must post to maintain the leveraged position — the position is liquidated. A user can add and remove margin at will under this method.
Practically speaking, if a user takes out a leveraged position for USDC and another for ETH, then isolated margins apply only to each position and not to any other. If ETH drops and the Maintenance Margin for ETH therefore spikes, the user cannot access the margin for USDC to cover the new collateral requirements for their ETH position.
The only way to avoid liquidation would be to deposit more money into the ETH margin account.
In Cross Margins, the margin pool is shared between positions. Using the example above, if ETH went down, the user could use funds from the USDC position to reach the ETH Maintenance Margin level.
The primary difference is that the user would not need to deposit additional cash.
In Portfolio Margins, the collateral required is calculated based on the entire portfolio’s underlying value, not only on what has been deposited in a margin account.
In Predy, it is also possible to use unrealized gains to offset unrealized losses, or as a margin to open new positions, thereby preventing unexpected liquidations.
Vaults = Portfolios
In Predy, we achieve Portfolio Margin through the use of vaults. One wallet can create multiple vaults, and each vault is considered a portfolio. The vault’s margin is then automatically calculated based on the vault’s total asset value.
A vault requires collateral that allows for a 7.5% price change based on the vault’s delta.
Types of Predy contracts
The Predy protocol allows users to take out the following contracts:
- Long power perpetuals (squeeths) which give the user a leveraged position with an unlimited upside and limited downside when compared to 2X leveraged positions.
- Automatic combination of Short Perpetual ETH offset by a Long Perpetual ETH² to hedge against impermanent losses (ILs). This is what allows Predy to provide a stable APY because impermanent losses are effectively nullified, allowing the user to cash in on the transaction fees regardless of how much the underlying asset price fluctuates.
- Similar automatic combination of Long Perpetual ETH and Short Perpetual ETH² to earn APY, similar to Opyn’s “crab strategy.”
For the first time ever, LPs can hedge against ILs, one of the biggest drawbacks of DeFi since the leverage market boomed.
Final audit completed, launch date set for April 2022
The Predy protocol has been completed and is set to launch in April 2022. You can check the latest news on Twitter, join our Discord, and connect your wallet to start trading with us when we officially launch in public beta!