Guillaume Lambert’s Panoptic

Out-of-the-money (OTM) puts and calls would provide users with an attractive strategy for implementing this strategy, removing the need to place all those orders as in a dynamic strategy. The problem is that I don’t see anyone wanting to sell them.

Unattractive Short Out-of-the-Money Put PnL

For the foreseeable future, one will not arbitrage volatility selling an LP position against another, as that requires low spreads. It took decades for that sort of liquidity to build up in tradFi, and we are not close. Even today in tradFi, those who arbitrage relative vol between two assets are almost always professionals with the lowest fees, capital requirements, and fastest trading platforms. Retail option traders generally have a view about the future price, not implied option movements, because they do not have the low-cost access that would make trading this profitable.

The OTM option sellers on Panoptic will see an unfamiliar payoff. Consider the retail tradFi payoff

Revenue: option premium (expected convexity cost)

Retail Cost: Max(strike – price, 0)

In Panoptic, assuming the AMM is priced at cost, we have

Revenue: realized fees (realized convexity costs)

Retail Cost: Max(strike – price, 0)

For Panoptic the revenue switches from expected to realized convexity (which, if priced correctly, shows up in LP fees). This dramatically changes the payoffs for the OTM option seller. For the happy case where the price rises, the payoff for the standard OTM put seller gets his option premium as pure profit. The Panoptic put seller, however, gets nothing unless the price ends close to his strike. For the unhappy case where the price goes down, the scenario is similar. [I had to break these two cases into different graphs because the downside pnl is so much larger.]

I don’t think retail put sellers will find this payoff attractive. The Panoptic put seller will be betting that the price will not go much below or above their strike, while a standard retail put seller thinks the price will increase. This is because in Panoptic the seller’s revenue looks like the graph below, quite different than what one sees in a standard option.

Panoptic’s OTM put is more like an out-of-the-money straddle. That’s a unicorn in retail option strategy because no one wants it.

In contrast, the standard at-the-money straddle is potentially attractive, as the differences are relatively minor between the Panoptic and standard option PnL.

More Problems

Several unwelcome features remind me of another Uniswap-promoted complementary product, Squeeths. This product was sold as a way to hedge LP risk by allowing people to go long perpetual gamma, the opposite of what is generated by the LP position (short perpetual gamma). It traded on the price of the underlying squared, such as squared eth.

However, to match an LP position’s gamma, the squeeth requires at least ten times the delta, which must be hedged elsewhere. The capital required would explode. A good hedge reduces required capital.1 Another terrible thing about squeeths is they are not like buying a variance swap, which is like a futures contract on variance. Instead, they are a sequence of forward-starting one-day variance swaps, meaning, if you thought volatility was cheap, by the next day, it would be repriced, so subsequent days are all afresh. Going long a squeeth was like a position on the future daily conditional expected variance over the realized variance, something not seen off the blockchain because no one wants it.

[I just checked the squeeth team's Twitter, and they are hiring developers, highlighting no one cares whether something has or will work, just that it’s plausible. I used to think squeeths were the worst idea I have ever seen on the blockchain, but that's reserved for in-game leveraged sports betting (the creators thought the standard 5% vig would magically disappear in-game). As if a bet where the payoff is +100 or 0 needs leverage.]

Similar to squeeths, Panoptic positions have some unattractive practical aspects (though, not that bad). For example, there does not seem to be a reason to use actual LP positions. These are created when the option seller mints the option, but if a buyer arrives, they are instantly exited. One could simply read the GlobalFee and liquidity for the relevant ticks off the Uniswap contract, get the requisite information, and avoid wasteful expense.

Then, there is the cost of a seller canceling. As the essence of an LP position is that the option seller can costlessly exit each block, this is a significant change to the base short gamma position. TradFi options require a premium because people must be paid for locking them in over time, as only the buyer can exercise early. Daily options are popular but they too require a payment, so it’s not like demanding the sellers don’t revoke their straddles for only a few days is irrelevant.

Lastly, the option seller pays a commission. Considering LPs usually lose money, I don’t think anyone will find selling options using LP positions as a base would make it an attractive stand-alone investment. The best targets are current LPs. One could give them the option to take their LP positions, and buyers would promise to give them the same payout, with an extra 5% or 10% on the fees. This would be easy to do, and the option sellers would be better off without cost or risk. Buyers could get long volatility without the vega premium one sees in tradFi, which could work.

Strangely, Guillaume occasionally mentions the low implied volatilities for Uniswap pools but has never documented this thoroughly. I would think showing how one can pay LPs 10% more and get access to long vega without paying the tradFi vega risk premium would be an excellent selling pitch. He could present various back-tests showing exactly how to make money or hedge volatility. Few people in defi—VCs, developers, or protocol CEOs—know much about the profitability of the most popular defi contracts, let alone how to take advantage of that.

I’m unsure what motivates this willful blindness to the actual profitability of the most active Defi contract. One cannot fix a problem that is considered taboo. I speculate that the lottery returns to prior projects that ultimately became zombies taught investors in this space to focus on the short term. Create something that looks like it implements something popular off the blockchain, note how it will be decentralized, etc., and ignore the details (eg, Augur). When everyone figures out the project is not viable, the insiders are all rich, and they move on to fund similar projects. Many faux-decentralized L2s and protocols exemplify this strategy.