Haptic Finance: A primer

Back in Q4 2021 the team was lucky enough to be granted a seat in Kain Warwick’s mentorship program for Optimism native projects #L222, with the initial aim to provide impermanent loss (IL) protection for automated market makers (AMM) liquidity providers (LP).

During the mentorship the team had the chance to brainstorm with brilliant people, a privilege which led us to examine the problem at hand from several perspectives and to conduct more research and simulations.

This resulted in pivoting away from the initial iteration in favor of a completely different approach: instead of protecting from IL, Haptic allows AMM LP to build their own strategies and profit from the market without external capital, other than the value of the LP shares. This is done using existing LP shares as collateral for derivative instruments such as options.

Options

Options are a type of financial contract which entails for the option writer the obligation to buy (CALL) or sell (PUT) an underlying asset at a given strike price when maturity is reached. On the other hand, the option buyer pays a premium and has the right but not the obligation to buy or sell an underlying asset at the strike price. An option is “in-the-money” (ITM) if the contract is profitable to exercise for the holder or it expires “out-the-money” (OTM) — worthless, in other words.

Options are financial instruments centered around volatility and allow experienced writers and traders to efficiently profit from any market condition.

Opinionated LP’ing

How can AMM LP use options to express directional bias and profit off the market? Let’s take as an example a DAI/ETH position deployed between the 1700 and 2000 DAI/ETH price band.

One scenario could entail a bearish LP who thinks the price will fall below the 1700 mark in the next 7 days. Under this circumstance, the LP could write one or more CALL options with a price close to their upper bound of 2000 DAI/ETH and earn a premium from an eventual buyer — if his intuition is right and the price falls, the option(s) sold expire worthless and he pockets the premium.

On the other hand, a bullish LP would write PUT options close or below the lower bound of their liquidity and hope the price will instead rise, causing the options to expire worthless.

Yet if the LP thinks that the market is is moving sideways in “crab” mode, he/she can write both PUT and CALL options and pick the strike prices and maturity periods accordingly.

Haptic Ecosystem

Haptic allows the creation of a option market for any risky/stable token pair traded on Uniswap V3. Markets are created by LP who deposit LP shares and use them as collateral for selling European-style binary options (at launch). There are three distinct roles in the Haptic ecosystem:

1. Option Seller: creates markets and provides liquidity by depositing Uniswap V3 LP shares and writing options for sale.
2. Option Buyer: acquires contracts from the market and has a right to exercise them at expiration.
3. Keeper: triggers settlement of ITM options and forces execution of far OTM options with the goal of receiving incentives.

Option Seller

Option sellers can write options backed by funds in their LP share. This allows them to express extra directional biases without the need for extra collateral and earn from the premium. In addition, LP will receive incentives designed to offset the risk associated with selling options.

The Haptic user interface guides the LP in the process of writing options as shown in the animation below.

Option Buyer

Option buyers deposit funds in the form of stablecoin and pay a premium to the seller for the contract. At expiration, the buyer receives the payout if the option expires ITM. If the option expires OTM, they receive nothing and the premium goes to the option seller.

Under some circumstances the protocol will distribute trading incentives to returning option buyers with the goal of partially offsetting the risk of losing the premium, similarly to “cash back” rewards seen in traditional binary options markets.

Keeper

The in-time settlement of contracts is crucial for the protocol to function correctly. For this reason, the protocol incentivises Keepers to trigger settlement of ITM options. When an option is created, the seller is required to transfer an amount of ETH calculated based on a rough estimation of the cost of exercising the contract plus a premium.

The ETH transferred and a fraction of the protocol fees are paid to the Keeper that exercises the option. Typically, keepers are bot operators and miner-extractable value (MEV) hunters.

Peer-to-peer market

Options are very popular in traditional finance (TradFi) and this fact is reflected with large trading volume for this type of instrument. Liquidity in traditional markets is often managed by professional market makers using proprietary technologies and option chains offer deep books and standardized strike prices, quoted for CALL/PUT contracts at given maturity periods.

Translating this process to options to the decentralized finance (DeFi) world is a bit involved for several reasons. Beside the computational constraints of the blockchain, unregulated markets make it hard for institutional players to participate and bring the know-how seen in TradFi to the space, which results in poor liquidity and fragmented markets.

Some protocols address this issue by adopting an AMM model for options, e.g. Lyra. Lyra leverages smart contracts to offer a standardized option chain where people can trade 24/7 and options are priced dynamically based on market factors and the impact of the trades on the available liquidity. Other protocols, such as DeriBit use a more centralized approach, which means it keeps customer funds in custody and manages all of its market operations internally.

On the other hand, options on Haptic markets are written directly by LP, who can choose any strike price in combination with available standard maturity periods. Buyers willing to transact on the platform interact directly with option writers through our smart contracts, in a peer-to-peer fashion.

Oracle-less Black-Scholes pricing

To correctly price options Haptic uses the Black-Scholes equation parameterized with a combination of Uniswap V3's TWAP and median prices — with implied volatility also sampled from Uniswap V3 . This approach allows us to keep the pricing logic entirely on-chain and not dependent on a external oracle, while still computationally and gas efficient.

Permission-less options

All options traded on Haptic markets are backed by funds in existing LP shares. Settlement and forced execution of options is triggered in a permission-less fashion by Keepers and the pricing of options happens entirely on-chain, without the need for a third party intervention.

Composable

Options in Haptic are tokenized using the ERC1155 standard. Multi-legged positions can be combined to create user-defined payoffs that are composable with other DeFi protocols, e.g. they can be traded or used as collateral in lending or staking platforms.

Current and future directions

The protocol will be initially deployed on Ethereum and the Optimism network, targeting more EVM compatible chains in the future. At launch, it will be possible to trade European style binaries with plans to expand to vanilla and more exotic types of options, e.g. American, Bermuda, barrier, as well as other types of derivative instruments.

In fact, combining the ability to borrow against third party liquidity and leveraging with the current design greatly expands the horizon of possibilities and allows the creation of a diverse set of financial products.

Roadmap

For more details on how Haptic works under the hood please read our litepaper and upcoming docs.

Don’t forget to follow Haptic on Twitter and join our Discord community.

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