Protocol Safeguards
SDX incorporates several safety measures to protect liquidity providers' returns in the face of volatile market conditions. These features include a Volatility Circuit Breaker and Trading Bands.
Vault Position Cap
Each option market has a specific cap on max position that the vault can enter. For example, a single strike for a SOL Call cannot take up more than 25% of all the capital of the vault. This position cap is in place to prevent concentrated risk in a few number of positions.
Minimum Tradable Delta and Mark Price
Vaults will trade options in a reduce-only mode when the absolute delta of an option or the mark price falls below the configured values, to limit gamma exposure.
Minimum Free Capital
Vaults will reject trades that results in free capital (cash and tokens that are not used as options collateral) falling under the minimum configured amount. This ensures that there's always partial liquidity available on hand to honour withdrawals or take advantage of trading opportunities.
Near Expiry Market Closure
Each market has the ability to pause trading at a certain amount of time before expiry. Market closures protect risk from being absorbed by the pools close to market expiry, where greeks are subject to large changes.
Oracle Confidence Level Check
SDX has implemented an Oracle Confidence Level Circuit Breaker to enhance trading fairness. This feature actively monitors the Pyth oracle price's confidence level for listed assets. Should the confidence interval exceed 1%, suggesting possible price inaccuracy, the platform will automatically pause trading. This measure is designed to prevent any unfair advantages that might arise from price dislocations, thereby maintaining the integrity of the trading environment.
Trading will resume once the price realigns with its true value or after manual intervention by the SDX team, ensuring that all market participants, including traders and LPs, are protected and operate on a level playing field.
Learn more about Pyth's confidence intervals here.
Trading Bands
Trading bands (min and max values for each greek) are configurable parameters that restricts the AMM from making orders that move portfolio greeks further away from the permitted range.
The visual aid below depicts two trades each with their own color, blue and red. Circles represent the delta prior to a trade and squares indicating the delta following the trade. The trade colored blue is an example of an acceptable trade, whereas the trade colored red would be declined.
Automated Delta Hedging for Liquidity Pools
On the SDX platform, Liquidity Providers (LPs) earn premiums from the spreads generated between buying and selling options. The pricing curves within our protocol are strategically designed to motivate external entities to adjust the LP pool's 'greeks' towards an optimal delta target of 0.5.
To further safeguard LPs from potential losses in market making, SDX has implemented an automated Delta Hedging strategy for its liquidity pools. This process is carried out by a dedicated keeper network, which is responsible for monitoring the pool's greeks and executing swaps. These swaps are only performed when the execution price is more favorable than the benchmark prices set by the Pyth oracle for the pool +/- a confidence interval, aiming to align the pool's delta to the target of 0.5.
Swap Pricing and Hedging Parameters
Swap prices are calculated using a Pyth oracles.
For situations where pool has greater than 0.5 Delta, the swap price = Pyth Price + the Pyth Confidence Interval.
For situations where pool has less than 0.5 Delta, the swap price = Pyth Price - the Pyth Confidence Interval.
The keeper network performs swaps across four distinct tiers. Each single trade can move the delta of the pool to a maximum of +/- 1% of the boundary of the next tier. The hedging parameters for each tier are:
Tier 1: Minimal Deviation
Applicable Delta Range: [0.47 to 0.53]
Swap Fee: 0 bps
Tier 2: Moderate Deviation
Applicable Delta Ranges: [0.35 to 0.45] and [0.55 to 0.65]
Swap Fee: 60 bps
Tier 3: Significant Deviation
Applicable Delta Ranges: [0.2 to 0.35] and [0.65 to 0.75]
Swap Fee: 70 bps
Tier 4: Extreme Deviation
Applicable Delta Ranges: [0 to 0.25] and [0.75 to 1]
Swap Fee: 80 bps
Keepers are rewarded with tiered swap fees to encourage the keeper network to execute swaps more promptly as the pool's delta diverges further from its target value and ensure LP safety.
Note: For additional safety, this feature is disabled if USDC depegs by more than 50bps as reported by a Pyth oracle.
Volatility Circuit Breaker
The Volatility Circuit Breaker is designed to address delays in updating historical volatility for options pricing during times of extreme market changes. Since volatility is a crucial input in fair option pricing, the circuit breaker widens the bid-ask spread when there is a significant shift in spot price. This helps to prevent taking positions that could be detrimental to flow. By expanding the bid-ask spread, DSOV can continue to offer liquidity in uncertain conditions instead of pausing entirely.
The circuit breaker is applied for a duration of when there’s an extreme change in spot price, within a duration of 10 minutes, that is higher than times of the expected price change given the mark volatility over the same time period. Both and are configurable parameters of the pool.
Whenever the circuit breaker is activated, the time value multiplier will be increased by a constant of or decreased by a constant of for ask and bid orders respectively.
One potential future upgrade for the circuit breaker is to allow it to be activated when significant trades are executed over a brief period, which could indicate a shift in implied volatility.
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