Is a 10-fold price return not doing it for you? How about 90x?
The latest structured-finance alchemy from the crypto industry allows traders to get exponential returns on the price of ether (ETH), already one of the world's most volatile assets.
Last week, the decentralized options protocol Opyn launched an ether derivative contract linked to a new index called Squeeth – a word play on “squared-ether.” The index tracks ether’s price change, raised to the power of two. It takes leverage to the exponential degree.
The basic purpose of the new tool is to give traders exposure similar to the highly leveraged bets they could get from trading options, but without the need to set strike prices or determine contract expiration dates, according to a Jan. 9 blog post by Wade Prospere, head of marketing and community at Opyn.
Squeeth turns the options trade into a perpetual contract and can be used as a hedge, Prospere told CoinDesk. On the long side – betting on price upside – the trade offers leverage without liquidations. Traders who take the short side – betting on prices to stay range-bound – can collect premium yield, he said.
“The ideal market condition to hold Squeeth is when a trader has conviction in the upward price movement of ETH in the short- to mid-term,” Wade Prospere, head of marketing and community at Opyn, told CoinDesk.
One contrast is with the ETH-2X flexible leverage index – a structure product offering 2X leverage where traders simply get double the underlying returns; think exponential versus geometric; a two-times or "2x" multiplier turns a triple into a sextuple; but a "squared" return turns a triple into a nonuple.
Holders of Squeeth will make more when ETH goes up and lose less when ETH goes down.
Say a trader purchases $1,000 worth of the Squeeth tokens. If the price of ether triples from $3,000 to $9,000, the Squeeth would go up triple-squared, or 9-fold – to $9,000 in this example. On the contrary, if ether halves to $1,500, Squeeth will see a less-than-linear decline, as represented by the curved payoff line below:
A key drawback is that Squeeth funding rates – the cost of holding long positions – are expected to be higher than a 2x leveraged position due to the product’s exposure to pure convexity. The constant funding bleed from the long position results in the oSQTH’s underperformance relative to the Squeeth index.
So far the product has received a warm reception from the crypto community, according to Opyn.
"On day 1, we saw huge Squeeth trading activity,” Opyn CEO Zubin Koticha told CoinDesk in an email. "There was huge buy-side demand."
"Because of this, more people were trading Squeeth than ETH-2x flexible leverage index, even though that pool is 6x bigger,” Koticha added.
In cryptocurrency trading, it's all about the x's.
Uniswap has seen over $12 million of the oSQTH tokens change hands since inception. Further, the ether-Squeeth liquidity pool (ETH/oSQTH) on Uniswap has raked in $6 million in total value locked – the most commonly used metric to measure the size of collateral invested in decentralized finance protocols. Traders providing liquidity receive fees, according to the official blog.
There is no free lunch in finance
While Squeeth provides a significantly higher upside than other instruments, it also charges a relatively high funding rate – a fee longs pay shorts for maintaining the bullish exposure.
In the "perpetuals market" – a widely adopted crypto-markets innovation designed to give traders easy leverage – long traders pay funding to short traders when the perpetual contract trades above the index price, and vice versa. The funding mechanism is designed to help keep the perpetuals price tethered to the price of the underlying asset.
Those costs still exist with Squeeth, but they're a bit tougher to see: The equivalent market price of oSQTH almost always trades above the Squeeth index, implying a premium – a de facto cost for traders who are going long.
At press time, the estimated funding rate was 0.29%. It doesn't sound like a lot, but that's a daily rate, so over the course of 365 days, compounded, the annual rate works out to about 65% – a costly vig that can eat into returns over time.
As such, the product is better suited for traders anticipating a big rally in a short period. Even Opyn's executives are quick to point out the dynamic.
“Holding a long Squeeth position for an extended period (> 1 year) during which ETH trades sideways or goes down in value will likely cause a loss in ETH-squared exposure of the long Squeeth position due to in-kind funding paid to short Squeeth sellers," Opyn’s Prospere told CoinDesk.
Simple as that, right?
Simulations run by Opyn, assuming constant volatility and funding rate, to illustrate the impact of in-kind funding, show that while the Squeeth rose 90-fold in the year to November 2021, the oSQTH token tracking the index rose 50-fold (graph below).
Blockchain security researcher Mudit Gupta said the product is "great for short-term trades, as it offers higher upside and lower downside."
According to Joseph Clark, a mechanism designer at Opyn, Squeeth can also be used as hedge along with ether derivatives on the decentralized exchange Uniswap V3.
Shorts prone to liquidations
While the constant in-kind funding collected from long positions ensures there are no liquidations due to margin calls, traders with short positions are still liable to having their bets forcibly closed out.
Traders shorting Squeeth are effectively short the oSQTH token and long ether collateral. That’s because they first need to deposit ether on Opyn’s platform as collateral – in order to mint the oSQTH tokens before shorting them on Uniswap. These traders earn a funding rate for taking on this position, paid by Squeeth holders.
If ether’s price suddenly were to jump, the margin call required to keep the squared short position fully collateralized would exceed any increase in the value of the ether collateral – leading to liquidation or forced closure of the short position by the protocol.
"Large daily moves in the ETH price become much larger when they are squared," Prospere said. "If the ETH price is increasing, users could need to top up collateral to avoid being liquidated."
At the recommended collateralization ratio of 200%, the ideal market condition to short Squeeth is when traders are convinced that the market is overpricing future price volatility – in other words, when the traders see fewer wild price swings ahead than in the prevailing views of the market.
So selling Squeeth is a bet on lower volatility. Of course, that doesn't mean it won't be volatile trading Squeeth itself.
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