Wall Street veterans are well-versed in the world of options trading, and platforms like Robinhood have opened access for retail investors, making options a significant driver of the traditional finance (TradFi) landscape. We might see a similar phenomenon unfold in DeFi.

While DeFi currently favors swap, borrowing, lending (curbs), and perp protocols, options hold a particular allure for retail investors compared to these instruments. Unlike buying an asset outright, options offer embedded leverage, allowing for amplified returns without liquidations. Imagine a scenario where your portfolio rockets 100%, not through buying and holding a volatile asset, but through strategically leveraging options. Unlike traditional margin trading, with options, you're not subject to forced liquidation. You can hold positions through market fluctuations, potentially maximizing profits.

DeFi needs to cater to this investor preference by translating familiar TradFi investment strategies to the blockchain.

Robinhood's success with options trading stemmed from its user-friendly interface, making it easy for retail investors to understand and participate in the options market. DeFi can learn from this by prioritizing an intuitive and accessible user experience for options trading.

Options are essentially contracts where you sell a promise based on price changes and timelines. Traditionally, market makers (MMs) play a crucial role in ensuring these promises are fulfilled. They achieve this by buying offsetting exposures to the options contracts, essentially creating hedges.

Ideally, DeFi could leverage Automated Market Makers (AMMs) to replicate the efficiency of traditional MMs. However, AMMs currently struggle with handling the complexities of derivatives like options. These instruments require a computationally heavy and human capital-intensive framework for automating the mathematical and statistical analysis.

Traditional MMs can sometimes miscalculate, highlighting the potential benefits of having competing entities in the mix. Artificial Intelligence (AI) could be a solution for training AMMs to become more efficient.

The compromise, in the meantime, lies in a hybrid system (DeFi 4.0) that combines on-chain and off-chain elements. This approach has been leveraged by Arrow Markets, tapping into the benefits of DeFi while attracting traditional finance players, ultimately leading to more competitive pricing for options in the DeFi space. Their sophisticated Request-for-Execution (RFE) system on Avalanche's C-chain goes beyond traditional Request-for-Quote (RFQ) systems by delegating trust aspects to the blockchain, ensuring efficient competitive options pricing. Looking further ahead into the next five years, envision DeFi 5.0, where AI is applied extensively in options market making. This future borrows inspiration from TradFi institutions like JP Morgan and XTX, who are exploring deep hedging and advanced AMM strategies with AI tools such as reinforcement learning. The most successful funds are already implementing AI  algorithms for market making. Integrating this kind of technology would be a game-changer for DeFi traders, but it requires significant advancements.

Currently, TradFi has the upper hand in AI research for market making, relying on centralized computing power. For DeFi to achieve pure on-chain market-making with Artificial Intelligent Market Makers (AIMMs), the challenge lies in decentralizing the AI algorithms themselves. Once this occurs, users will have the opportunity to back the AIMMs as LPs. The AIMMs will then use the LP funds to finance the hedges against the options contracts that the AIMM buys or sells. 

Finally, even as AIMMs are introduced, there is no reason not to allow human MMs to participate and quote competitively alongside AIMMs as long as they are sufficiently collateralized in order to fulfill their obligations. Such a system will need to have a robust risk management margin system at its core, which can analyze the overall risk and financial health of the MMs (AI or human) to make sure that, with a high degree of confidence, they will be able to satisfy their options payout obligations (promises).

By tackling these challenges, DeFi can unlock the full potential of options for its users. The journey may involve a blend of innovative solutions, from hybrid systems to cutting-edge AI, but the ultimate goal remains clear: empowering DeFi traders with the tools and strategies that resonate with them.

Author:

Edward Mehrez is a co-founder of Arrow Markets, pioneering a new paradigm for options trading on the Avalanche blockchain. Arrow offers the efficiency of centralized exchanges with the transparency and security of on-chain settlements.

Prior to Arrow, Edward honed his expertise in quantitative finance at MKP. He holds a strong academic foundation with a Bachelor's degree in Mathematics and Economics from UCLA and a Ph.D. in Economics from Cornell University.