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No protocol is immune to bugs or hacker attacks, no matter how many unit tests, integration tests, and third-party security audits are performed. To safeguard the DAO's treasury against these risks, we will be utilising on-chain derivatives with our partner platform.
Example Hedging Strategy
Let's say we want to buy a $1 million hedge against the risk of a third-party protocol going bust. We would do this by buying weekly American digital put options with a strike price that is 50-70% less than the current price of protocol token. We would pay a small premium for these options, and we would roll them over every week to stay protected as long as we have exposure to the third-party protocol strategy.
How does protection work?
If the price of the that token drops by 50% (which we are using as a proxy for protocol going bust), the option will pay us $1 million. Even if the price doesn't drop below our defined threshold, the price of our option will have likely increased significantly, and we can sell it in the market for a profit.
How do options work on the platform?
The option trade is deployed on-chain with Unison as the buyer and a market maker as the seller. The market maker is willing to take on the risk of a third-party protocol failure in exchange for the premium we pay. The option is continuously monitored at every new price point, and if the price drops below the strike price, the buyer receives the payoff.
Why buy weekly options that need to be rolled over, instead of a single long-term option?
This is done to keep the cost of protection low. We are looking for protection against a sudden crash in the price of protocol tokens, not for protection against a gradual decline in value. If the price of the token were to decline gradually over a long period of time, it is likely that the protocol itself is still safe, but that it has simply lost its usefulness.
Why buy digital options instead of vanilla options, given that vanilla options will have a non-zero payoff even if the Protocol token doesn't drop below our defined threshold?
The reason is the same as the above. Buying vanilla options would be more costly, and since we do not want any protection as long as the protocol is functioning smoothly, we should not pay any premium for getting a payoff against small drops in the price of tokens.
Why buy American options instead of European options?
We want to get the option payoff as soon as there is a crash. American options can be exercised at any time, whereas European options can only be exercised at expiry.
Keep an eye on this page, more to come.