The disruptive change brought by decentralised finance (DeFi) presents an opportunity to democratise financial products by making them easier, faster, and cheaper to access. DeFi promises a world where financial programs can share the same operating system, allowing data to transfer freely between collaborating applications. Decentralised derivatives are the next burgeoning trend along this arc of innovation, allowing separate DeFi primitives such as the order book, price oracle, and options traders to create a shared platform for decentralised derivatives.
We’re thrilled to be working closely with Zeta Markets, who are one of the leading decentralised derivatives platforms on Solana. In this Spotlight report, we provide a quick refresher on the Zeta Markets project, followed by an overview on how their platform will utilize Serum’s architecture to create a fast, liquid, and ecosystem-oriented DEX for Solana futures and options.
Winners of the ‘Solana Season’ hackathon, the Zeta Markets project set out to build an under collateralized derivatives exchange, enabling anyone to effectively hedge risk against crypto market movement and events.
In the early stages of ideation, core contributors to the Zeta Markets project realised that the base layer for complex derivatives like options needed to be high-speed, high-throughput and fully decentralized.
Zeta initially explored multiple other chains, but settled on Solana as the primary contender due to the throughput and the responsiveness of the Solana blockchain, and the unique orderbook primitive that existed in Serum, allowing a CeFi-like experience on Solana.
Zeta’s thesis is that true price discovery, and deep liquidity occur via orderbooks in the long-run, and Serum has enabled a unique primitive built by Zeta — A hybrid OMM-orderbook approach, which will define DeFi option trading for years to come…
Our goal is to provide a platform where traders aren’t sacrificing ease of access, capital efficiency or liquidity, and instead have a professional-grade platform to trade derivatives on a number of crypto-centric underlyings.
DeFi derivatives are ripe for innovation
Web3 opens up a large number of possibilities and risks with digital ownership. Risks in crypto can get complicated, and having the tools to protect against those risks is becoming increasingly important. Here are some of the benefits Zeta believe they can offer to the world of decentralised derivatives:
Speed and Efficiency
- Building a derivatives protocol on Solana provides traders the ability to trade at lightning speed on the Serum orderbook with almost zero cost, unlike current platforms which force developers to build parts of their program off chain or on Layer 2 to keep costs down for their users.
- Zeta’s proposed AMM — the Options Market Maker (OMM), will provide superior yields to Liquidity Providers (LPs), as well as encourage liquidity by making markets on every product listed. They use a dynamic Options Market Maker (OMM) that takes in information from every trade to determine a fair option value, responding in the same way a ‘real’ market maker would. This allows for infinite horizontal scalability to any tail liquidity tokens and strikes.
- Collateral is significantly reduced on Zeta’s options platform. This is due to the millisecond block times offered by Solana and the robust liquidation engine that’s able to be built around more frequent mark to market updates. They also recognise that options in conjunction are often less risky than standalone, and actively reduce trader’s required collateral for spreads, strangles, straddles, flies and more.
- Zeta’s priority is to provide products that real crypto natives care about. They will be looking to list not only derivatives on spot prices, but derivatives on blockchain information, gas fees, funding rates and more — with community feedback at every step.
Decentralised Options Markets
Many established options markets in DeFi use an AMM to price their premiums. AMMs are great for bootstrapping the liquidity of a market, however, they leave important variables out of scope when it comes to pricing options. This can lead to stale prices on the premium of the options, and as a result, can generate large amounts of impermanent loss for liquidity providers.
Order books allow you to state the exact price for the purchase or sales of your options. This allows liquidity providers to update the prices of their options in real time to reflect changing market conditions. Of course, with order books, fulfilment of your order is not guaranteed, and you must wait for someone to take the other side of your trade.
The Zeta Markets project is in effect, combining the options AMM model, with an order book to provide a hybrid options market consisting of both the orderbook and an options market maker (OMM). This is where the project takes advantage of Serum as a core module for their application. The Serum order book is the most active way a user would directly interact with Zeta. Each strike price has its own distinct market ID on the Serum order book, allowing traders to place orders for options at the exact price (premium) they want. The OMM is a virtual counterparty that helps bootstrap the market, sending orders directly to the Serum orderbook, and providing a baseline level of liquidity for traders to buy and sell options against. The OMM gives liquidity providers a way to interact with Zeta passively through its robust options pricing algorithm.
Pricing options is more complicated than the method of price discovery that AMMs alone provide. This is because options pricing considers the probability of a future event (the expiry price). Traders have different ways of calculating options prices, but one of the common tried and tested mathematical models for options pricing is the Black-Scholes-Merton (BSM) formula. Zeta’s OMM uses the BSM formula, taking into account the real time changes in volatility of the underlying, to price the options it places onto the Serum orderbook.
In practice, the Zeta OMM actually uses a derivative of BSM options pricing formula — Black-76.
The model inputs:
- Forward Price: Is calculated using the underlying price provided by the oracle, the risk free rate and the time till expiry.
- Volatility: Of the underlying asset is calculated by the on-chain volatility surface that the OMM maintains.
- Risk Free Rate: Is derived by the OMM which stores the risk free rate curve.
- Strike: Is the price predefined in the contract for which to buy or sell the underlying — this a parameter defined in the options contract.
- Time to expiry: Is the point in time when an option will be exercised — this is a parameter defined in the options contract.
Using these parameters and the Black-76 pricing equation, the options price is determined by the OMM, creating a passive options market making strategy for liquidity providers, and bootstrapping the trading of decentralised options on the Serum orderbook.
For more information on the mechanics of the Zeta OMM see here.
Zeta’s devnet product is live. To illustrate how its vanilla options protocol leverages Serum, take note of the two sided market above with orders available for SOL/USDC call options at a strike price of $189. The orders have been placed into this market by the OMM, waiting for active traders to trade against them. The order book allows you to place an order on either side at your desired price. If your price crosses the spread, some or all of your transaction will be traded against by the OMM. In this version, the OMM is limited in its scope and ability to provide liquidity and so generally orders placed by the OMM are currently of 25 units.
You can try out their devnet product at https://devnet.zeta.markets/
Each strike price for different options (call/put) initializes a unique serum market per option product (that’s a lot of Serum markets!). This is made possible with Serum’s new permissioned markets functionality, containing Zeta’s markets within the confines of its own application, whilst maintaining all of its logic on chain.
The Zeta Markets project has been built with capital efficiency in mind. Zeta Markets will provide cross margining for trading undercollateralized options, meaning that the users entire portfolio are treated as one one account for the purposes of leverage. All open orders accounts are paired up with the user’s margin accounts to process trades with respect to their available margin. Everything is completely on chain.
The product has been built in a way where Serum markets are actively reused after an option series has expired, creating a circular buffer of markets in chronological expiry order. This requires them to clean each market and use smart contract logic to ensure they are “ready” to be traded again after expiry.
They have also built the platform in such a way that makes all taker orders and order cancellations atomic with the instruction that checks user margin account state. Therefore the only thing the event queue needs to process is the update to the user margin accounts on maker trades.
The new Serum Core provides some key benefits for developers building order book traded decentralised derivatives on Solana.
In future versions they may look to migrate Zeta to Serum Core to gain the flexibility on the fee structure, and also remove boilerplates around the SPL token logic in the existing Serum Dex. since those tokens are just used for the serum smart contract mechanics.
Agreement value accrual
Serum and Zeta have agreed on a long-term strategic partnership where Zeta will rely on the ongoing development and maintenance of Serum’s unique orderbook technology as a core module for its decentralized options exchange.
Strategically, both Serum and Zeta have committed to supporting the growth of ecosystem partners, with both parties exploring further integration of derivatives products in future.
Decentralised derivatives on Solana are a great example of how DeFi primitives can come together to create something bigger than the sum of their parts. Zeta Markets is a prime example, and we look forward to the coming wave of innovative primitives and derivatives platforms.
We’re excited to see how DeFi derivatives mature and create even more interesting financial products.
Read Serum Roadmap 2.0
Listen to Sam Bankman-Fried’s breakdown of the Serum ecosystem