Volatility tokens are a new Defi Primitive, adding a much sought-after innovation to Defi.
By buying and selling Volatility Tokens, traders can easily trade volatility on DEXs and even CEXs, making the Crypto Volatility Index (CVI) much more composable and accessible to the greater DeFi ecosystem.
The main difference between trading volatility in the platform and with the volatility tokens is that while the CVI platform is account-based, meaning each Long position is tied to a specific address similarly to most other DeFi protocols. The volatility tokens are tokenized long positions that can now be used as a lego piece inside other DeFi protocols. Users will be able to generate more yield on them, easily access them on Dexes and generate revenue by arbitraging.
- 1.Peg to the index via the CVI platform The CVI platform is in essence an AMM (Automatic Market Marker) that constantly sells volatility, while the volatility tokens represent a share in a shared pool of a LONG position. Whenever a token (either CVOL or UCVOL) goes off-peg with its respective volatility index, an arbitrage opportunity is created. This allows the volatility tokens to be freely traded, while always remaining pegged to the index (Whenever a deviation from intrinsic value occurs, an arbitrage opportunity incentives a quick return to peg)
- 2.Full hedge and delta exposure to its respective index A common usage of the VIX ETFs is for hedging and as such, it is a key requirement that the tokens are designed to work as a hedging tool. In order for the tokens to serve as a full hedge they must fulfill two requirements: Requirement 1: Fully backed by counterparty liquidity. This means that if CVI goes to its maximum value of 200, the tokens can be fully redeemed with no exceptions. In order to create an always-available source of counterparty liquidity which fulfills this goal, the CVI is built around an AMM. The AMM allows liquidity providers to deposit collateral, which is used as counterparty for the volatility tokens. As the volatility tokens represent a long position on the index, the AMM ensures that at all times there is enough counterparty liquidity to cover the scenario of CVI going to its maximum value of 200. Liquidity(t) =( 200CVI(t)- 1) * CVOLTotalSupply(t) The architecture of having volatility tokens on one side and an AMM which sells volatility on the other side allows the tokens to be used as full hedge, as there is always an available source of liquidity to cover profits from a rise in CVI. Requirement 2: Maintain exposure of 100% (or higher in case of leverage). A key aspect of this requirement is that as CVI goes up, there will not exist a mechanism which incentivizes closing the position, such as asymmetrical gains. For example, given that the CVI spiked from 80 to 120, excluding time decay, CVOL token holders would have a 50% profit, while given that it moved to 160, excluding time decay, CVOL token holders would have a profit of 100%. P&L(t) CVI(t) - CVI(t0)CVI(t0) * CVOLBuyAmount
- 3.Accounting for time decay As the CVI is range bound [0,200] and is mean reverting, we can observe that any token which is pegged to it would have to incur a mechanism for time decay. Without such a mechanism, it would be possible to mint/swap into the token at values below mean and hold it indefinitely until profit. To account for time decay, the volatility tokens are built as a unified long position on the index, which pays a funding fee over time. However, this has a repercussion that if the tokens were regular ERC20 tokens, then due to arbitrage between DEXs and the CVI AMM their price on DEXs would over time decline in value, preventing them from keeping peg with the CVI index, thus losing semantic meaning. In order to address this issue, the volatility tokens implement the ElasticToken interface, pioneered by the Ampleforth project. The elasticity allows the tokens to be negatively rebased, thus holding them over periods of time results in having less tokens in the holder’s wallet. This trait allows the tokens to keep their peg with the CVI index, while accounting for time decay. The rebase mechanism runs fully decentralized with the usage of Chainlink keepers, which activate it every day at midnight UTC. It’s important to note that the rebase action is purely semantic, there is no added benefit to selling/buying the tokens before or after the rebase occurs. Without the rebase, an arbitrage between the DEX and AMM would have caused the token price to depreciate in value, thus losing peg, while the rebase instead lowers the token supply which allows keeping the peg. In the event there was no arbitrage between the DEX and the AMM, the result of the rebase operations would be a token price higher than its intrinsic price on the AMM. Overall, the peg is kept by the combination of allowing arbitrage to flow between the DEX and AMM, in combination with the daily rebases. The following table summarizes the effect of both arbitrage and the rebase operations:
CVOL (Range bound 0-200): it’s the first volatility token in the market that is pegged to the implied volatility of both, Ethereum and Bitcoin, by being pegged to the CVI index. CVOL can be traded in the Arbitrum network on SushiSwap and Polygon network on QuickSwap . By buying the token on a DEX, the user holds a LONG position on the CVI index.
UCVOL (Ultra CVOL - Targeted to maintain peg with x1.5 leveraged CVI via arbitrage. Range bound 0-400): After achieving the new CVI V3 design goals with the creation of the Theta Vault, which will allow a sustainable and scalable source of liquidity for the CVI volatility tokens on any secondary market and decentralized exchange, we introduce Ultra CVOL (UCVOL), the leveraged token for the CVI index.