Calculation Methodology of the Crypto Volatility Index (CVI)
Foundational Model: Black-Scholes Option Pricing
The Crypto Volatility Index (CVI) is fundamentally derived using the Black-Scholes option pricing model. This model plays a pivotal role in computing the implied volatility from cryptocurrency option prices. Alongside this, it integrates an analysis of the market’s expectations regarding future volatility, thus providing a comprehensive view of market sentiment.
Essential Data Sources and Market Dynamics
The efficacy of the CVI calculation hinges on the availability of a robust options exchange ecosystem. This ecosystem must encompass well-defined rules, active market makers, comprehensive order books, and substantial turnover to yield reliable option prices. A crucial aspect of this calculation is ensuring the integrity of the option chain; gaps or inconsistencies in this data can lead to inaccurate volatility assessments.
As part of our data aggregation process, we utilize a variety of sources like Deribit, recognized for its advanced platform and widespread adoption in the derivatives and options trading space. By leveraging these sources, we can effectively analyze and interpret market expectations of future volatility, addressing the unique liquidity challenges inherent in the cryptocurrency market.
Technical Integration and Decentralization
To maintain decentralization and transparency in the CVI calculation process, we employ the Chainlink architecture. This system utilizes multiple independent oracles, each equipped with external adapters. These adapters are responsible for retrieving trading options data from across the market. The responses from each oracle node are then aggregated to form a singular, consolidated price index.
This aggregated index is subsequently broadcast onto the blockchain. Once on-chain, the data becomes accessible for smart contracts, enabling them to execute critical on-chain functions. These functions can range from settling derivatives contracts to adjusting trading strategies based on real-time volatility metrics.
The combined CVI index is a weighted sum of CVI indices calculated for several cryptocurrencies (for example BTC and ETH), where weights are set in accordance with the asset market capitalization.
CVI Chainlink External Adapter
In order for CVI to source data from premium off-chain APIs and perform custom calculations on that data, we need to make use of Chainlink External Adapters. The External Adapter allows smart contracts to connect to Chainlink nodes, send them a specific list of tasks to execute (called a Chainlink Job Spec), and identify a list of possible ways to schedule them (called an ‘initiator list’). The initiator allows us to trigger the job spec, and we will be using the Chainlink Cron initiator to schedule our external adapter to run specific time intervals.
Chainlink allows complete freedom with external adapters, as they can be written in any language and operate as serverless functions on AWS / GCP. We will be using a dockerized Node.js server to issue API calls to crypto derivative options exchanges such as Derbit, LedgerX, OkEX, and CBOE.
CVI Calculation + Data Aggregation
Due to the high cost of repeatedly dispatching and updating values on the Ethereum blockchain, the CVI calculation and data aggregation will be done off-chain inside the CVI External Adapter. The final result is then sent on-chain to the CVI Oracle Contract as a single value — the CVI index.
At regular intervals, Chainlink oracle nodes fetch market data on cryptocurrency options contracts from multiple data provider APIs and aggregate the data off-chain (in the CVI external adapter) using the Black-Scholes option pricing model, weighting assets by market cap to create a single reference price point for the CVI.
This reference price point is compared to the previous on-chain update and if it is beyond a specified deviation, the Chainlink oracle node performing the check initiates a round update for the Reference Price Feed by creating an on-chain transaction with their data.
Once other oracle nodes in the oracle network see the initiation of a new round, they each perform the same data sourcing and aggregation process, responding with their CVI data on-chain.
After a sufficient threshold of oracle nodes have responded on-chain, each node’s response is aggregated together to generate a single tamper-resistant reference data point. This refined CVI data point is then made available to external contracts which can be used for the settlement of derivatives contracts and other DeFi smart contracts.
The process then repeats, with nodes checking if updates should occur at regular intervals and monitoring for round updates from other nodes. This ensures the on-chain CVI Reference Price Feed is always kept fresh with tamper-resistant and high-quality market data reflective of real-time market conditions.