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Ep 40 Potion case study
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TLDR below. This is not financial advice.
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Potion is quite a new protocol and it doesn't have any tokens yet. This is interesting because you realise that sometimes, these protocols do not really need the tokens. Tokens could come in at a later stage when it starts generating value and you can socialise the value gains to all these different stakeholders. But the first thing or the most important thing in your protocol especially in finance or in DeFi is really to build the right kind of algorithms and this is what potion is doing really good.
I want to talk about this because it does not have a token. But there are still economic mechanisms and incentives to discuss. It doesn't always need to have a token.
1. Recap: Put Options as Insurance
The put option is where you get to sell your asset at a fixed price or an agreed-upon price. This is good because if the prices drop too low then you can have a put option at the price that you're comfortable with.
For example, we're talking about ethereum being $1700. You put a put option that allows you to sell it at $1700. Let's say ethereum falls to $900. With this option, it allows you to sell it at $1700. That is how you get to use put contracts as insurance.
This is a good way to mitigate risks as buyers and this is good because the space is very volatile and when we create products we want to look at how to structure different things to make sure that buyers are protected and more buyers can come into space and grow the DeFi ecosystem.
2. Problems with Existing Options
Unscalable Liquidity Architecture: You can create option products but you can't exactly trade them in the secondary market and this is a good problem to have because then it really suggests a more mature secondary market and we're not at that stage yet in the DeFi space so that is something to look forward to and worth innovating in this space.
Limited Market Availability: Options or Derivatives are not very easy products so there are still some limitations to liquidity or trying to get more people into space.
Unreliable Pricing: This is interesting because a lot of options models that we use is the Black-Scholes model which is not exactly the best and there are a lot of problems with that especially when we're looking at very risky and volatile products and the Black-Scholes model doesn't really help to aggregate this kind of information.
European Options: A lot of the options that we talked about so far are all European pricing and European Options mean that you can only execute them when they expire but one of the benefits of options is that you can execute them anytime you want. This is the American style of options.
3. Mechanism Design: Governance
In Potion they don't have a governance token or a native token. Governance token usually comes in decision making but we don't have any decisions to be made yet. We do want to look at resolution and remember there are keeper bots in the system. This is where resolution comes in.
If the protocol keeps calling to UMA to get the oracle pricing, that is going to be very expensive for on-chain fees. What the protocol does is that it will take off-chain oracle data like CoinGecko or other sources.
Let's say the price of ETH is $1700 and this $1700 will be used to input into the bonding curve to determine the price of premiums that users have to pay. As a user, I might realise that ETH has changed so much that by the time I'm given the premium to pay it is actually worth $1600. This difference of 100 bucks will be reflected in the premiums that I pay because it might be higher. I don't want to do that and this is where i have a conflict so there is a hundred dollars difference. This is where the governance in terms of resolution comes in to deal with it.
4. Mechanism Design: Bargaining (Pricing)
Prices are determined differently for different kind of protocols. Option pricing could be determined or matched via exchanges. When it is determined, this is where a lot of bonding curve aspects could come in.
One thing to consider as a protocol is the probability of the liquidity pool going to zero. This will really determine what kind of pricing models we're going to look at and what the bargaining strategy is going to be.
Initially the system used the the Black-Scholes model which is something that is used by a lot of other protocols. Because it has been tested and won the Nobel prize. That is something that a lot of people are comfortable with, however there are a lot of limitations to this model.
Assets in the crypto space are a lot more volatile and uncertain so the Black-Scholes model might not always be the best kind of model. It could still be useful for certain types of products and a certain type of assets but it might not be useful for most types of products, so this is the bargaining mechanism.
5. Token Design: Financial Incentives
In the system right now the protocol doesn't have any revenue and all the premiums will be returned to the liquidity pool and divided among the liquidity providers so this is how it is working and they're probably going to start expanding this a little bit more because we have the keeper bots. These keeper bots will be getting some profits as well because these are incentives to make sure that they actually solve the problem as keeper bots exist in the resolution phase and if your items are mis-priced or the pricing strategy is not right then this is where the keeper bots come in and we have to get some profits.
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Potion Protocol is currently in the development phase, with simple product structures making it accessible to everyone. Innovation comes in the pricing of option premium to really reflect the volatility of the underlying asset.
Get smart: Pricing based on actual volatility/risk creates fairness for both buyers and sellers.
Ps: Order the textbook "Economics and Math of Token Engineering and DeFi" today!