Price volatility is one of the biggest deterrents of the crypto market, dissuading newcomers from trading or investing in cryptocurrencies like Bitcoin (BTC) or Ether (ETH). Extreme market conditions can trigger billions of dollars in liquidations, making it less than ideal for institutional investors as well.
Reports show that almost 40% of people who have not purchased crypto are hesitant to do so because of price volatility. So, it’s no surprise that the crypto space has tried to come up with decentralized finance (DeFi) solutions that would help investors hedge against market volatility.
The best available solution for traders to manage their risk came from outside the DeFi ecosystem. The 50-year-old Black-Scholes options pricing model is a method used by traders to determine fair premiums for options. These options enable traders to buy or sell a particular asset at a set price on a future date. It has been widely used by numerous asset markets in traditional finance (TradFi) long before the existence of cryptocurrencies and debuted as crypto options when Deribit launched Bitcoin options trading in 2016.
Why is the TradFi options model inefficient for crypto markets?
While the Black-Scholes model allows traders to mitigate the risk associated with changes in the underlying asset’s price, creating a $13 trillion market in 50 years, it doesn’t automatically translate well to the crypto market for several reasons.
First, it relies on assumptions like constant volatility, lognormal asset price distribution, and frictionless markets. When those assumptions do not hold true, like when Bitcoin and Ether become less volatile than oil, the model creates pricing inaccuracies.
A 90-day chart showing the price volatility of Bitcoin, Ether and oil. Source: Kaiko
Coming from traditional finance, the Black-Scholes options model is also known for its inability to account for events like market crashes and extreme price movements. Overall, traditional options contracts are expensive and overcomplicated without a game plan for the times when protected assets jump in value.
Crypto-native derivatives with DeFi 3.0
DeFi has come a long way since it first appeared, building upon previous iterations with every new one. DeFi 1.0 marked the inception of blockchains as a financial ecosystem, circumventing traditional centralized systems. DeFi 2.0 expanded on this concept with improved liquidity, scalability governance and security.
Now, we're heading to DeFi 3.0, which promises a significant leap in innovation by introducing enhanced liquidity mining and staking mechanisms, perpetual derivatives, NFT lending and cross-chain interoperability. These progressive features make it possible to offer a better and more crypto-native alternative to traditional options contracts.
Launched on Sep. 7, DeFi protocol Bumper presents a new way to protect the value of users’ crypto assets from bear cycles and market crashes while preserving gains when the price charts are flashing green. By pricing contract premiums based on actual volatility instead of past volatility during the term of the position, Bumper premiums are, on average, 30% lower compared to observed market prices for ETH put options on Deribit and other crypto options platforms.
Calculated based on market activity and protocol health, dynamically priced premiums are designed to minimize the cost of protection, making Bumper an attractive alternative to options contracts.
How to protect from crypto volatility
After connecting their wallet to the Bumper protocol, users need to adjust a protection floor and a term length. Once crypto assets are deposited into Bumper, users will receive a composable token for the asset, which represents the protected asset with the downside volatility removed.
When the price of protected crypto assets goes up, users can retrieve their original tokens at the end of their term. If the price goes down, users will receive stablecoins worth the chosen floor level instead. The users who provide USD liquidity to the protocol will receive a yield of 3% to 18% in USD Coin (USDC) from the premiums paid by protection takers.
Bumper users who wish to open a position for protection or earning need to hold the protocol's native BUMP token in their wallet, which is bonded during the span of their term and returned when the position is closed.
Disrupting a $13-trillion market
Bumper uses innovation made possible by blockchain, including peer-to-pool liquidity and smart contracts, to eliminate the need for third-party involvement while removing the risk of the counterparty failing to deliver on expiration. Bumper’s novel architecture represents one of the most notable financial algorithms since the Black-Scholes formula was conceived over 50 years ago.
The DeFi protocol has launched with ETH protection, with wBTC and other assets in the pipeline. To celebrate its launch, Bumper is distributing a total of $250,000 in incentives among early users, which is skewed toward those coming in earlier and taking longer positions. Bumper CEO and co-founder Jonathan DeCarteret said:
“By challenging and potentially reshaping the accepted norms of options pricing, Bumper stands to revolutionize not just the crypto market, but also has the potential to change traditional finance and disrupt the colossal $13-trillion options market.”
The evolution of DeFi introduces new primitives and structured products never seen before. With products like Bumper, the DeFi ecosystem creates a launchpad for exotic, novel and groundbreaking financial products. The new horizons sighted by DeFi 3.0 pave the way to financial innovation that will propel crypto away from traditional finance to become a self-sustaining ecosystem.
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