SOFA Structured Products: EARN & SURGE

Using SOFA structured products to express market views offered several advantages over taking the same exposure on offchain or centralised alternatives.

• Trading options positions onchain removes counterparty risk as settlement is ensured by the verifiable logic of a smart contract and full collateralisation.

• Trading on SOFA offers exposure to the RCH token, which is airdropped to users on a periodic schedule. These tokens are awarded to users according to the proportion of volume that they trade in each recording period.

• Onchain positions in SOFA structured products are tokenised using leverage the ERC-1155 token standard. This allows for custom position parameters to be stored on the token itself, allowing for a more accurate valuation of the position so that it can more easily be composed and used as collateral in other trades.

What are Structured Products?

Structured products combine different types of investment products, such as bonds and options, in order to achieve an enhanced yield on an investment note. The combination of investment products can be chosen to target a risk and return profile that is tailored to the investor’s market views. Yields are enhanced when the investor’s view differs from the view priced in by the market.

Structured products come in many flavours, but one concept that distinguishes between their risk profiles is the concept of capital protection – how much of the initial investment is at risk in the case that the investor’s market view is incorrect.

Principal Protection (EARN)

With the lowest risk, Principal protection (EARN) products act to protect the investor’s original investment and provide opportunity for an enhanced yield. A portion of the capital invested in the structured product is invested in instruments that generate a yield over the life-time of the product.

The remainder of the initial investment is used to buy optionality that expresses the investor’s view. If the view is correct, the investor earns an enhanced yield from the upside payout from the optionality, the generated yield and their initial investment. Otherwise, the investor is returned only their initial investment and the generated base yield.

Capital at Risk (SURGE)

SOFA’s Surge product offers a much higher potential return in the case that the investor’s view is correct, but risks more of the initial investment. In this type of product, the trader targets exposure solely in products with higher potential returns, such as options, that carry a higher potential risk. This means that the structured product is able to target much higher potential yields by selling an option on an outcome that the investor thinks is less likely than is priced in for by the market.

Where do the Enhanced Yields Come From?

As the now-classic DeFi adage goes: “if you don’t know where the yield is coming from, you are the yield!” While offering a complete innovation in democratised access to finance, DeFi has unfortunately also become notorious for offering inexplicably high yields above those offered to users without a clear source. In many cases, yields are funded by obfuscated risks to the investor’s capital, or even by unsustainable tokenomics that payout early adopters with the investments of new joiners.

That’s not the case with structured products, which have sustainably offered investors customised products with enhanced yields in traditional finance for decades. Returns on their capital above those offered by lending markets by allowing them to take clear, calculated risks that align with their market view.

For example, optionality can be sold on outcomes that the investor thinks is unlikely or probability of occurring is over-priced by the market. When the investor is correct, the option premia collected is converted to an enhanced yield on the original investment that far exceeds those yields offered on safer, principal protected investment notes. In the case of products that target a mix of yield generating products (like lending markets) alongside the optionality exposure, these yields are combined with the base yield earned from yield generating products.

Structured Products on SOFA

When implied volatility is high options premia are higher, and therefore structured products that offer an enhanced yield by selling optionality are far more attractive. This provides the opportunity for higher returns when your market views disagree with the option.

Similarly, high yield environments offer a more attractive chance to take advantage of principal protected notes, as the increased risk-free yield is able to fund a larger position in options. The high implied volatility in crypto-asset derivatives markets is one reason why structured products linked to the performance of crypto-assets are so attractive.

EARN vs SURGE

SOFA currently offers two payoff types, both of which are available as an EARN or SURGE product.

EARN aims to offer a return of some or all of the initial investment:  

• Part of the initial principal is invested in AAVE lending markets, offering a yield on the sum invested at the end of the term
• The rest of the initial capital is used to buy or collateralise optionality
• In the case of a Bull or Bear Trend product, the investment is used to buy a call or put spread respectively
  • If the market view expressed by the investor is correct, then the options expire in-the-money at a profit that is converted to an enhanced yield on the original investment
  • If incorrect, then the investor’s losses are capped to the premia paid for the options
• In the case of a rangebound product, the investment is used to collateralise short binary call and put positions at the upper and lower bounds
  • If the market view expressed by the investor is correct, then the options expire out-the-money and the premia collected by selling the options is converted to an enhanced yield on the original investment
  • If incorrect, then the investor’s losses are capped by the portion of the investment used to collateralise the positions, and compensated for by the yield generated in AAVE lending markets
• At expiry the investor receives a base yield (plus a bonus yield via airdropped tokens) regardless of the performance of their market view

SURGE:

• Like in the EARN product, the investment is used to buy (Trend) or collateralise a short (Rangebound) options position. However, the full amount of the initial investment is used to target much larger returns
• If the investor’s market view was correct, they receive a much higher upside yield earned from buying or selling optionality than they would have if expressing the same view using the EARN product.
• If incorrect, they do not receive the upside yield, and do not receive the base yield at expiry that is offered by the EARN product. The investor’s losses are capped to the original investment.

In both cases the investor qualifies for airdropped RCH tokens that act as an additional yield enhancement on all products as a reward for trading on SOFA.

Market View - Rangebound

The Rangebound product is for the investor who believes that the underlying asset will remain “range bound” when the market has priced in a higher volatility. If ETH does not cross above a chosen upper bound or below the chosen lower bound at any time before expiry, the investor receives their upside yield.

This product can be thought of as selling a string of binary call options at the upper expiry and a binary american put at the lower expiry, both of which yield a higher premium to the seller when implied volatility is high. However, if the reference price crosses either strike at any time before expiry, then the investor loses the binary bet.

As an example using the SURGE product, a user may invest 20 USDT in an ETH-underlying Rangebound note with a tenor of 1 week. Choosing their lower and upper strikes at $3,300 and $3,700 respectively, they stand to earn a return of 2.5x (50 USDT) if ETH stays within that range throughout the week. If ETH crosses above or below either barrier in that time, then they receive their airdrops only.

Market View - Bull or Bear Trend

Opposite to the Rangebound product, SOFA’s trend products are for the investor who believes that the underlying price will rise (bull) or fall (bear). When investing their notional in the Bull trend product, investors must pick lower and upper strikes. If ETH trades below the lower strike at expiry then the investor receives no upside yield. However, beginning from the lower strike, they receive an upside yield for spot levels between their bounds that is maximised when spot is at or above the upper bound.

Where the Rangebound offers an enhanced yield by selling optionality at its upper and lower strikes, the trend products take advantage of a combination of a long options position and a short options position. The bull product can be thought of as investing part of the original investment in a call spread position, with the bear trend product the same in a put spread.

This means that the position is most attractive when implied volatility is lower, offering a more competitive entry point to the long call spread. More specifically, the position offers the highest potential upside yield when the price of the long call option at the lower strike is compensated by a high premium collected from selling a call option at the upper strike.

By decomposing the bull trend product in this way into a long call at the lower strike and a short call at the upper strike, we can see that the investor is cheapening a directionally long market view by selling upside beyond a certain price target. The same in reverse is true for the Bear trend, which can be decomposed into a put spread.

Again using the SURGE product to illustrate, a user may invest 20 USDT in an ETH-underlying Bull trend note with a tenor of 1 week. Choosing their lower and upper strikes at $3,500 and $3,800 respectively, they stand to earn a maximum return of 1.5x (30 USDT) if ETH trades above the higher strike of $3,800 at expiry. If ETH trades between the two strikes, then the return is lower with the minimum return occurring when ETH trades below the lower strike, resulting in the earning of their airdrops only.

The details of the products discussed above can be adjusted to more accurately express an investor’s view on the market further enhance their potential yields.

SOFA Protocol Strengths

Using SOFA structured products to express market views offered several advantages over taking the same exposure on offchain or centralised alternatives.

Firstly, rather than face the counter-party risk inherent to holding deposits on a centralised exchange, trading options positions onchain removes counterparty risk as settlement is ensured by the verifiable logic of a smart contract and full collateralisation.

Secondly, trading on SOFA offers exposure to the RCH token, which is airdropped to users on a periodic schedule. As SOFA is run by a profitless DAO, USDT denominated fees collected by the platform are used to purchase RCH tokens in the AMM / liquidity pool to be burned, applying a buy pressure to the token that benefits its holders (more on the tokenomics of RCH can be found in the docs here). These tokens are awarded to users according to the proportion of volume that they trade in each recording period.

Finally, onchain positions in SOFA structured products are tokenised using leverage the ERC-1155 token standard. This choice allows a single smart contract to mint and control many different token types at once cheaply and efficiently, which allows SOFA to manage many custom option positions cheaply and efficiently.

The token standard also allows for those custom position parameters to be stored on the token itself, allowing for a more accurate valuation of the position so that it can more easily be composed and used as collateral in other trades. For example, tokenised positions in SOFA structured products can be used as collateral on other protocols and dApps, allowing for increased capital efficiency without compromising full collateralisation.