Decentralized Options Clearing House on Qredo

# Decentralized Options Clearing House on Qredo ## Qredo Qredo combines a fast-finality blockchain (Layer 2) for digital asset tracking and settlement with a Consensus-Driven Multi-Party Computation (CD-MPC) network, and a secure, end-to-end encrypted decentralized conversation replication network (Layer 3) to handle everything from machine to machine communications to storing and providing an audit trail for regulated pre-trade communications. A distributed ledger is used to record the ownership of a Layer 1 crypto asset, which is represented by a synthetic token/wallet combination on the Qredo blockchain and maps one to one in value to the asset’s wallet on the Layer 1 blockchain. ### Decentralized RFQ Qredo’s Layer 2 / Layer 3 design includes an **automated, decentralized RFQ bot that is built into the Version 2.0 protocol.** Qredo’s decentralized RFQ (Requests for Quotes) system securely interacts with Market Makers and enables private pre-trade negotiations between a Trader User and another known counterparty to finalize a P2P transaction, enabling a ‘Bloomberg Chat’ like experience for all users. The RFQ bot enables a simple Uniswaplike Web3 interface to facilitate the exchange of Layer-1 assets (BTC / ETH) using Market Makers that have staked and bonded QRDO tokens with a Validator. Market Makers take part in the token rewards scheme and are incentivized to offer the best prices and market depth. **Any trader on the Qredo network can create atomic swap transactions with any DEX that Qredo can access and a) arbitrage trade across multiple DEXs and b) completely offload the counterparty delivery and settlement risk to Qredo Loan Pools, for a fee.** In other words, a trader can create atomic swaps between DEX’s on the same Layer-1 chains (ETH) or even between different Layer-1s (ETH to BSC, ETH to BTC, etc.) without being detected by the Dark Forest and have immediate settlement. **Multi-leg strategies are also easily executed with this capability.** The protocol charges traders 0.5 basis points of both maker’s and taker’s trading principal. If for example two traders were exchanging BTC for ETH, the protocol would obtain ETH and BTC. The protocol exchanges Layer 1 assets for QRDO tokens using the protocol’s Request For Quote mechanism which queries both Market Makers and DEXs on multiple networks. ### Qredo 2.0 Built-In Primitives * **Risk-Free Settlement** - Qredo can confirm transactions between users in seconds with no counterparty, settlement or payment risk, including Layer 1 atomic swaps (BTC for ETH), or crypto-to-fiat transactions (ETH for GBP). * **No Pre-Funded Wallets** - Qredo eliminates the need to pre-fund wallets, eliminating settlement and delivery risk on centralized crypto exchanges. Qredo enables centralized exchanges to sync the state of their central limit order book post any trade, triggering the atomic swap of assets on market and limit order fills, yet still preserving the privacy of makers and takers. The centralized exchange performs the role of settlement orchestrator, invoking the atomic swap transactions between makers and takers on the Qredo network. Makers and takers keep their digital assets in their Qredo Network created wallets, under their control, up until the requirement for settlement and delivery materializes because their orders are filled on the exchange. The exchange never touches or has to receive their customer’s digital assets. * **Loan Pools (single sided LPing)** - Loan Pools are single-sided pools with their own Layer 1 outward facing wallet that interacts with dApps programmatically via functionality in the Validator’s Broker module. For liquidity providers, they will resemble a short term money market fund whose function is to primarily loan digital assets to borrowers on the Qredo Network at short durations, at highly leveraged ratios (8x - 10x). Interest rates are set with a PID controller. Qredo’s choice of Layer 2 / Layer 3 and enterprise ready Integration Libraries create a foundation that enables developers to rapidly create stand alone applications that extend the Qredo capabilities resulting in rapid time to value. Qredo developers have created a DeFi proxy software program installable on Windows, Mac and Linux that enables a trader to stay in the dApp’s native interface, but be connected to the Qredo network. Wallets interacting with the dApp are intercepted by the proxy and routed into the Qredo network. From there, custodian approval workflows, signature aggregation, transaction encryption, Validator verification and block inclusion happen behind the scenes. To the dApp trader, there is minimal to no difference in user experience. ## Options ### Historical Motivation The goal for options is to let participants speculate on financial assets. Options create a seperation between the asset price into two components - market price and speculation. In 1973, the Chicago Board of Options Exchange (CBOE) began trading. For the first time, options contracts were properly standardized and there was a fair marketplace for them to be traded. At the same time, the Options Clearing Corporation was established for centralized clearing and ensuring the proper fulfillment of contracts. As opposed to the over-the-counter options market, which had no set terms for its contracts, this new exchange set up rules to standardize contract size, strike price and expiration dates. They also established centralized clearing. ### Options order flow Option traders are not necessarily interested in probability distribution at expiration time – given that this is abstract, even metaphysical for them. In addition to the put-call parity constrains that according to evidence was fully developed already in 1904, we can hedge away inventory risk in options with other options. If you hedge options with options then option pricing will be largely demand and supply based. This in strong contrast to the Black-ScholesMerton (1973) theory that based on the idealized world of geometric Brownian motion with continuous-time delta hedging then demand and supply for options simply not should affect the price of options. If someone wants to buy more options the market makers can simply manufacture them by dynamic delta hedging that will be a perfect substitute for the option itself. ## Responsibilities of an Options Clearing House ### Components * **Mark to Market (MTM) margin** covers the cost to liquidate securities positions at current market value * **premium margin** which covers the cost to liquidate option positions at current market prices * **additional margin (risk margin)** which covers the additional projected cost of liquidating all option positions in the event of an assumed worst case change in the price of the underlying. ### Calculations & Process * The first step in calculating margin requirements is to **net long and short positions** in the same series of options. Only the net long or short position in each series of options (symbol, put or call, expiry month and strike price) is counted for margin purposes. * The next step is to **calculate the Mark to Market (MTM) Margin** for all securities contracts in the class group. MTM margin represents the proceeds from selling the long position if it was liquidated at the current (higher) market price. Likewise it represents as well the cost to buy back the short position. * The next step is to **calculate premium margin** for all options in the class group. Premium margin is calculated for each series of options by multiplying the net long or short contract quantity by the contract size by the closing price of the options series * For exercised and assigned positions, premium margin is a credit for the exercised long position (presuming it is In-The-Money) and a debit for the corresponding assigned short position. Premium margin for exercised and assigned positions is calculated by multiplying the net exercised or assigned contract quantity times the contract size times the difference between the strike price of the exercised position and the current market price of the underlying. * The final step is to **calculate additional or risk margin** for the class group. Using an options pricing model with implied volatility for each series of options, the clearing house forecasts the potential gain or loss on the portfolio of positions assuming a maximum upwards and a maximum downwards movement in the price of the underlying as well as at a number of intermediate price points ### Risks The clearing house typically assumes no market risk because, as central counterparty, for every long position it holds there is a corresponding short position, and vice versa. It is, however, exposed to the risk that one or more of its clearing members might default on their outstanding contracts. This exposes the clearing house to credit risks (replacement cost risks) and also to liquidity risks. - **Replacement Cost Risks** - If a clearing member defaults, the clearing house faces replacement cost exposure because the member's default does not relieve the clearing house of its obligation to the clearing member on the other side of the contract. The clearing house would generally replace the contracts by going into the market and purchasing or selling contracts identical to those on which the clearing member defaulted. - **Liquidity Risk** - When option premiums are paid upfront and passed through, the clearing house has no buyer exposure, but has a current exposure at inception to the seller as well as a potential future exposure. On the other hand, if the premium is not paid upfront and passed through to the seller, the clearing house initially has no current exposure to either the buyer or the seller, but has a potential future exposure to both. If the market value of the option increases, the clearing house will be exposed to the seller; if it decreases, it will be exposed to the buyer. - ****Principal (delivery) risks**** - Clearing houses can incur large credit exposures on settlement days, when the full principal value of transactions may be at risk. This can occur if upon expiration (options) contracts are settled through delivery and delivery versus payment (DVP) is not achieved. - If a commodity or underlying instrument is delivered prior to receipt of payment, the deliverer risks losing its full value. If payment is made prior to delivery, the payer risks losing the full value of the payment. In some cases, the sequence in which deliveries and payments will occur is known in advance and principal risk is clearly asymmetric. - Many products traded by derivatives exchanges call for cash settlement rather than delivery, and principal risk is thereby eliminated. ### Qredo questions * Build an options clearing house that standardizes options trading on Qredo? * Use an updated options pricing mechanism? (fk black scholes) * MMs underwrites options by providing the underlying assets (10eth = 1 contract size) and enters an agreement with a trader to buy at a pre-determine price sometime in the future. * Expires ITM -> MM exchanges 1 eth to trader for 1 eth (at strike) + premium. Premium is paid by trader upfront. * Expires OTM -> MM keeps the premium and doesn't exchange with trader because there's no point. * **If MM tries to solicit bids from a bunch of traders, this is inefficient and each trader will want to negotiate a different price. Hence there needs to be standardization so that contract exchanges can be exchanged more easily.** Could use Qredo RFQ to settle the underlying orders? * If another trader is willing to pay a higher premium, they can exchange the difference in premium to the first trader permitted they have the capital to actually exchange the underlying ETH. * The big idea is that the protocol should work as a way to batch orders together into variable contract sizes in a marketplace. We wouldn't have to worry about settlement because Qredo is self-custodied. * The protocol will give the right, but not the obligation to execute options contracts and automatically match parties together (via an RFQ system?). * We can verify sufficient liquidity for users because we can just query the self-custody health status for participants. If they don't have sufficient assets to execute the trade, then nothing happens. **(where does this go?) Note that both Ribbon SSOV's and GMX use net settlements. They don't require the underlying assets!! I don't think we want this** ### References [5.2 Risks of Potential Defaults by Clearing Members](http://ifci.ch/138770.htm) **IMPORTANT SOURCE!** [Clearing House Sources of Risk](http://ifci.ch/138700.htm) [FTX Liquidation Engine](https://help.ftx.com/hc/en-us/articles/360027668712-Liquidations) [Qredo White-Paper](https://www.qredo.com/qredo-white-paper.pdf) ### Will Notes 10.11.22 * american options not really used in traditional finance because they are really expensive beause the right to exercise at any time (american options premium is way higher bc right to exercise is very valuable) * cant do physical settlement with long tail shitcoins * you can see this in action using zeta (change in value of underlying) https://www.zeta.markets/ * zeta market documentation talks about undercollateralization * physically settled = exchanging underlying asset * cash settled = exchanging in a stablecoin * DOV is physically settled? Ribbon does "net settlement" in difference in the underlying, which is physically settled. It's not settled in cash.

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