Options analogy

InfinityPools’s mechanism can be explained using traditional finance instruments such as options and margin trading. If you are not familiar with those, feel free to skip this section.

Trading

While InfinityPools traders feel as though they are margin trading with no liquidations, the payoff is that of a synthetic in-the-money (ITM) option. InfinityPools traders create this payoff by initiating a margin trade and buying an out-the-money (OTM) option with a strike at the margin trade’s hypothetical liquidation price. The OTM option's notional and maturity both match the margin trade’s.

Let’s imagine a trader is looking to long ETH/USD on InfinityPools with 10x leverage and the current market price of ETH is 1000 USD:

  1. The trader would start by borrowing USD and buying an OTM put option with a strike price of 900 USD since 10x leverage means a hypothetical liquidation price of 10% below market price:

  1. Swapping the borrowed USD for ETH (using any spot exchange) would then initiate the margin trade and create the desired synthetic ITM call option payoff:

As you can see, the synthetic ITM call option payoff is very similar to that of a regular margin trade but without liquidations. Terminating the margin trade would convert the payoff function back to the OTM one. This ability to switch back and forth at will between in/out-of-the-money allows traders to lock in profits at any time and immediately realize the value of their position in USD, at any time before loan and option maturity.

Additionally, if InfinityPools doesn't have enough liquidity for an OTM option at the given strike (green line below), it automatically combines OTM options at different strikes (red and grey lines below) to recreate the desired payoff for the lowest available premium.

This new synthetic OTM option (purple line below) also works for the trade above as it has a strictly better payoff than the initial OTM option (green line below).

Maturity profile

InfinityPools’ option and loan maturity are exponential with a half life of one day.

Despite this, traders have constant exposure to ETH/USD. This is achieved by continuously rolling over both the margin trade and the option as they expire.

So, why use an exponential maturity instead of a more conventional one day maturity?

  1. Having an exponential maturity means that all options expire on the same schedule, no matter when they were created. This eliminates fragmentation across expiries.

  2. It mitigates certain types of attacks known as MEV in crypto (similar to HFT trading strategies such as frontrunning) that would otherwise happen if the margin trading assets had to be swapped over at a predetermined time every day.

  3. The math for pricing exponentially maturing margin and option trades works out incredibly well. In our simulations, InfinityPools' equations priced trades more accurately and more efficiently (cheaper computationally) than Black-Scholes.

Loan & option styles

InfinityPools has three instruments that can all be exercised differently:

  1. Fixed term loan - this instrument is similar to a European synthetic option as it cannot be exercised before it matures (that said, same as a European synthetic option, you can still lock in profits at any point).

  2. Revolving loan - this instrument most resembles an American synthetic option but is more powerful as traders can get a refund on "unspent" premium. In other words, if a trader pays a premium for an hour long trade but decides to exercise after 30 minutes, they will get back 50% of their paid premium.

  3. Periodic loan - this instrument is a combination of the previous two, and is the main InfinityPools trade mechanism. Periodic loans start as fixed term loans and switch over to revolving loans after a preset lock in period.

Providing liquidity

The counterparties to the trades described above are called liquidity providers. These investors occupy a similar role to market makers in traditional options and spot markets but are more passive.

One of the defining characteristics of InfinityPools is the fact that the options mentioned above are created from loans of spot liquidity. In other words, imagine if a trader was able to borrow limit orders on a spot orderbook (InfinityPools uses a concentrated liquidity AMM, which is conceptually similar). By borrowing these limit orders and paying a premium upfront, the trader would then reserve the right to buy or sell an asset at a given price for the duration of the loan. This is what defines an option.

A few particularities of concentrated liquidity AMMs before diving in deeper:

  • Liquidity providers have something similar to resting spot limit orders at every tick across a given price range.

  • Each of these spot limit orders is fully collateralized (a limit order to buy 1 ETH at 3000 USD will be backed with 3000 USD).

  • These orders are also reversible (if a buy limit order is hit, it pops up as a sell limit order at the same price plus spread - and vice versa).

Traders looking to buy OTM options do so by borrowing these limit orders. As a result, liquidity providers are simultaneously providing liquidity to a spot market and selling covered options when required.

The interesting implication here is that InfinityPools liquidity providers do not have a lower bound on the length of the maturities of the covered options they are selling, but do have an upper bound (exponential with a half life of a day):

  • The first insight is that liquidity providers' have the same payoff when selling very shorted dated covered options as when just providing regular spot liquidity (while getting higher yields in the former scenario). As such, liquidity providers have no need for a lower bound on the maturity of the covered options they sell. This is crucial to enabling higher levels of leverage as those trades require extremely specific maturities that would otherwise be hard to match.

  • The second insight being that liquidity providers do not want to be "locked in" for long amounts of time (the exponential maturity in InfinityPools's case).

Premium calculation

Liquidity providers generate yield from two separate sources: the premiums from the covered options they sell and the transactions fees collected from spot trading activity in the InfinityPools AMM. The premium for selling covered options is calculated by multiplying two numbers:

  1. The first number is the minimum premium that liquidity providers get paid for selling a covered option. It is the output from a calculation similar to how the Black-Scholes equation is derived. However, as mentioned above, the InfinityPools equation is both computationally simpler and more price accurate than Black-Scholes.

  2. The second number is called a utilization rate and is the output of a function that responds to supply and demand for leverage in the market. It allows the market to bid up the first number when there is additional demand or if there is an arbitrage opportunity.

Assuming the sum of the premiums (generated by selling covered options) and fees (generated by the spot AMM liquidity) adds up to $50 for a given duration, the payoff for a liquidity provider that deployed assets at 900 USD would look something like this:

InfinityPools's advantages vs. options markets

At the core of InfinityPools's mechanism is an automated market maker. This enables capabilities that would otherwise be impossible or very hard to do with traditional options markets. Here are a few benefits that arise from these new capabilities:

  • Permissionless market listing: any fungible asset that can be traded can have a market created for it instantaneously.

  • Higher leverage:

    1. Creating options out of spot liquidity allows them to be sold on a much more granular level in terms of available strikes (theoretically unlimited). The closer an option strike is to the current market price, the higher the leverage multiple it enables on InfinityPools.

    2. The ability for traders to get a refund on unspent premium makes it possible for them to provide collateral in an incremental fashion rather than all upfront -- without fragmenting liquidity. This, in turn, also enables much higher levels of leverage on InfinityPools than would otherwise be possible.

  • Reduced liquidity fragmentation:

    1. InfinityPools enables the usage of spot liquidity to create options and, as a result, derivatives with any payoff. Since spot liquidity is required for any options market, liquidity no longer needs to be fragmented across two different markets.

    2. Options being sold across a larger number of strikes also means that InfinityPools can more accurately recreate desired payoffs by combining options at different strikes.

    3. InfinityPools's exponential maturity eliminates fragmentation across expiries as all positions have the same maturity profile.

Why build InfinityPools as a decentralized exchange?

Here are some financial reasons we decided to use a blockchain (Ethereum) as the settlement layer for InfinityPools as opposed to a more performant centralized venue:

  1. By codifying the InfinityPools mechanism in smart contracts, desired outcomes are enforced. This enables a wide variety of benefits including the ability to be non custodial and eliminating counterparty risk for cryptocurrency native assets or credit risk for tokenized "real world" assets.

  2. Blockchains are also fantastic coordination systems that allow exchanges to settle transactions 24/7 in a verifiable way. This means that trades can settle almost instantly rather than in the usual T+2 way and without some of the increased operational costs that are usually associated with it.

  3. Finally, blockchains also allow for increased composability of protocols and assets. The InfinityPools benefits listed above make for a strong foundation upon which other teams can build innovative products.

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