🥈Secondly
As market makers, the risk exposures of LPs are shown in the following chart: direction, time, volatility, and interest rate.
As the sellers in the option, market makers have to take the risks above accordingly. Among the four dimensions above, time value and interest rates are friendly to the sellers. LPs deposit assets in the liquidity pool and the basic returns come from interest rates. It helps to understand it if you think of the returns of LPs on lending platforms like Compound and AAVE. This is one of the sources of earnings of market makers.
Another source of earnings is coming from the time value of an option. Here we need to understand the five Greeks that affect option pricing: Delta, Vega, Theta, Gamma, and RHO. They are the main risk measures of option value which represent the sensitivity of options in spot prices, implied volatility, time decay, as well as the changes of interest rates. As exercise time approaches, the value of an option is gradually decreasing, which is a disadvantage for the buyer but a benefit for the seller. So that Theta, which indicates the time decay, is the second dimension of the option seller’s return.
After removing two positive factors, we have two disadvantages left, namely direction and volatility, which are correspondingly represented in the Greeks by Delta and Vega. Therefore, the main challenge solved by WMM-DDH is to hedge the risk of Delta and Vega instantly. Let’s take a look at the figure below:
The DDH calculates Delta and Vega for each option contract in the pool every once a certain time, and trades spots from the S Pool to hedge Delta and Vega in order to keep them at zero, so that market makers do not need to worry about these risk exposures. It can be said that WMM-DDH can achieve stable and positive returns for market makers under normal conditions. In addition, our developers have conducted an extensive risk assessment on WMM-DDH, and we found this design is fully feasible.
Compare with other DeFi option protocols’ liquidity pools such as Hegic, FinNexus, Charm, etc., there are still risks exposed to market makers. Although it was designed as a peer-to-pool mechanism, it only weakens a small part of the risk, the potential of loss still exists. It is worth mentioning that Charm’s liquidity solution uses AMM to create liquidity, and generates different option vouchers through a bond curve, and expresses the risk coefficient of each option through a variable function. Both buyers and sellers could clearly know the risk exposure of their positions, which facilitates arbitrage or risk hedging on different platforms. However, the defect still exists. Because Charm’s single liquidity pool is too scattered, the liquidity of different underlying assets cannot be shared, which would largely limit the efficiency of funds. At this point, the buyers and sellers of KAKI's DDH pool trade through stable coins, which is more conducive to the buying and selling of retail options, so it brings the fund pool greater potential. The stable income of the market maker would effectively stimulate the expansion of the capital pool, thereby further promoting the improvement of liquidity and forming a long-term virtuous circle of the capital pool.
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