Why DeFi Option Vaults Should Not Charge Fees

Should the DeFi Option Vaults Worth $700 Million Charge Fees to Investors?

Defi options vaults (DOVs), a type of DeFi structured product based on options trading, have become a sensation from the second quarter of 2021, attracting the attention of retail Defi investors and various institutional institutions. From the beginning, DOVs have developed dramatically to become a significant portion of the $700 million Defi option TVL, having a trading volume of billions of dollars per month. The largest DOVs include ThetaNuts, Ribbon Finance, StakeDAO, Katana, Friktion and PsyFinance.

Investors place their money in the vaults, and the vaults invest the money in various options. Before DOVs, option strategies were only available to qualified investors through OTC internet trading or self-execution on options exchanges like Deribit. Distinctive base yields, typically 15% to 50% have been achieved via vanilla covered call and cash-covered put techniques. In addition, tokens are given out, resulting in an even higher return for users.

Hedge funds that are actively managed often carry a “2/20” fee. This entails a 2% management charge on assets under management (AUM) and a 20% profit performance fee.

Several hedge funds have abandoned the 2/20 paradigm these days. The 2/20 strategy is regarded as exceedingly costly and is only used by elite hedge funds that routinely beat by a significant margin. On the other hand, index funds have been pushed towards a zero-fee approach. Passive funds are expected to have no expenses, yet renowned index fund managers like Vanguard can still charge a 0.06 percent management fee.

Why the large gap in fee structures?

Hedge fund managers are paid a premium for originating and executing special strategies. These could be discretionary active-trading strategies, or algo-based systematic strategies, or even high-frequency trading strategies. The premium is paid for ‘alpha’ or active strategies that are able to outperform the general market.

On the other hand, index funds do not get this premium because they deliver passive strategies that do not require any special input from the fund manager. These strategies could be anything from buying a basket of stocks or bonds to structured derivatives strategies.

Index funds could get strong returns, but that would still not warrant high fees as the returns are generated from passive strategies working well in a favourable market and not because of any special effort from the fund manager. Similarly, Crypto DOVs such as Ribbon and Friktion are charging exorbitant management and service fees to crypto investors. Due to this, it does not make sense for DOVs like Ribbon and Friktion to charge fees to crypto investor’s users.

What role do DOVs play?

DOVs belong to the same category as index funds because of the passive nature of the strategies that are being executed. DOVs currently execute covered option strategies for their users, typically 10-15 delta strikes on 1-week expiries. There is no active trading or special algorithmic system.

The beauty of DOVs is that these simple strategies perform very well due to the structurally high implied volatility of the underlying asset. Covered option strategies are very common and can be easily executed on exchanges like Deribit or OTC desks.

The DOV protocol is primarily an infrastructure provider. They provide access and make it easy for the Defi user to execute these strategies in a trustless manner. A nominal management fee is perhaps acceptable for Ribbon Finance and other DOV protocols for this service. However, zero fees protocols such as ThetaNuts provide more value to investors considering the nature of the strategy implemented.

The DOV protocols do not deliver anything extraordinary strategy-wise as a platform provider. For the facilitation of passive strategies, DOVs, in our opinion, have no reason to charge any performance fees.

To any TradFi investor, charging performance fees on weekly covered option strategies would be shocking and seen as extreme profiteering. This should not be tolerated just because it is DeFi. For the DOV space to grow sustainably, the industry players need to put users first.

Is it fair for DOVs to charge performance fees?

Hedge funds that charge performance fees always have a clawback mechanism (or high watermark). This protects investors by allowing the investor to take back performance fees from previous years if there are losses in the most recent year. This way, the fund manager cannot take performance fees in one good year then leave the investor to bear all the losses in subsequent years.

Zero Fees products such as Thetanuts are the future for decentralized DOVs.

Without these clawback features, DOVs that charge performance fees expose investors to asymmetrical risk-reward, haircuts on profits and full impact on losses. These fee-charging DOVs effectively benefit from all the upside without taking any of the downside risks. Not quite fair to users.

Impact of fees on DOV returns

The main concern for any DOV user should be the negative impact on profits. While it might not be obvious to the investors weekly, levying fees on vaults severely impact DOV returns over time. To illustrate the effect of charging fees, the data shows a backtested performance of cash-secured puts strategies on BTC in 2021*, comparing four scenarios.

Looking at the graph above, one can see how differing charge structures have a significant negative influence on the return created for consumers over the course of the year 2021. Investors choosing a DOV that charges both a 2% AUM and a 10% performance fee will lose the most money.

DeFi Products and Decentralized Asset Management - Whats in the Future

There are various use cases and appropriate justifications for charging different sorts of fees to investors when employing structured products. However, there is no need to collect any fees in the case of individual option vaults that are executing an automated option strategy.

The rise of protocols such as ThetaNuts that offer zero fees against the fee-based structure of Ribbion is going to be the next paradigm shift in the crypto ecosystem as the fees structures become completely decentralized and more focused on the community itself.

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Image credits: @QCP Capital and Dane Deaner.