Smilee Finance Explained: New Era of Options
Understanding what primitive for Decentralized Volatility Products (DVPs) are, including volatility-based products and strategies.
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Introduction
1. Smilee Protocol Overview
2. Impermanent Loss As a Feature
3. Being Friends with Volatility
4. Gaining on Impermanent Losses
5. Team Behind the Protocol
6. Involved Players
Conclusion
Introduction
Recently, on our research platform, we covered a new narrative known as LPDFi (Liquid Providing Derivatives Finance). There are protocols actively using Uniswap V3 LP positions to build products on top of it. LP tokens that Liquidity Providers receive from providing liquidity act as yield-generating assets. This process enables the creation of new protocols like options, perpetuals, lending platforms, and others. If you want to fully understand what LPDfi is, make sure to read our latest article related to this concept.
We compared different protocols pioneering the LPDfi space, including Logarithm Finance, Panoptic, InfinityPools, Limitless Finance, and Smilee. The last one is our portfolio company, which offers the first-ever Impermanent Gain options, providing up to 1,000x leverage with no liquidations. In that article, we will dive deeper into how Smilee utilizes impermanent loss as a feature and uses volatility as the gain instrument.
1. Smilee Protocol Overview
Smilee Finance is the first primitive for creating decentralized volatility products (DVP). DVP is a storage-based strategy that generates payouts for participants based on their long or short positions depending on volatility. Thus, liquidity providers can also turn their impermanent losses into profits.
One of the main distinctions of Smilee Finance is that they aim to overcome one of the web3 problems related to UI and UX. This is because predominantly complex protocols have an overloaded interface accessible only from PCs. This limits the entry threshold for users. Moreover, Smilee seeks to make a rather complex product, an open-source protocol that allows the use of volatility-based products and strategies. Thus, users will be able to have a simple experience with a highly complex product. First, we will understand how the Smilee Finance protocol works, and then we will move on to studying the product as users see it.
Smilee Finance was originally a fork of Aave, as in the beginning the team thought it was the easiest way to launch an initial product turning DEX liquidity into volatility (also they call it Impermanent Gain). But it was later decided to move on to a different concept, as the initial option limited the ability to create other types of options and derivatives on the network in the future.
The data collected during this bear market clearly shows that liquidity providers on the DEX are not being adequately compensated for the risks they are taking. Uneven trading volumes, high volatility and the difficulty of managing ranges make APY difficult to predict, volatile and, after exposure to volatile loss, below the risk-free rate.
2. Impermanent Loss As a Feature
To begin, let's revisit the concept of Impermanent Loss in DeFi. It refers to the potential value shifts encountered by liquidity providers in liquidity pools due to the fluctuating value of tokens compared to simply holding them. This loss is labeled "impermanent" as it is realized only upon withdrawal and can vary over time. While liquidity providers earn fees, they also bear the risk of losing value compared to holding tokens. Automated market makers (AMMs) such as Uniswap are vulnerable to impermanent loss, prompting innovative solutions like those pursued by projects like Smilee Finance.
Liquidity providers (LPs) encounter Impermanent Loss during market volatility, resulting in underperformance compared to an equal-weighted portfolio. Impermanent Loss takes the form of a concave function, resembling a short volatility position. In return for this risk, LPs receive yield. The amalgamation of short gamma exposure and long theta exposure aligns the liquidity provider's payoff with that of an options seller, notably without a traditional options buyer in the equation.
Smilee sees this not as a flaw but as a deliberate feature. They analyze and replicate the Impermanent Loss payoff by selling a diverse portfolio of options. This involves constructing a matrix of payoffs for each option within their replication grid. By progressively introducing more option strikes to the market, they enhance the accuracy of approximating Impermanent Loss.
In a groundbreaking move, Smilee breaks down Impermanent Loss into options, paving the way for a new primitive. This primitive facilitates the creation and sale of any option at any strike, irrespective of whether someone initially sells that option. This effectively resolves the chicken-and-egg dilemma for options Automated Market Makers (AMMs), establishing Smilee as a protocol that other platforms can adopt to manage on-chain risks in a highly adaptable manner.
3. Being Friends with Volatility
Smilee introduces a concept as the first primitive for volatility, enabling the creation of Decentralized Volatility Products (DVPs). DVPs are vault-based strategies that generate payoffs, allowing users to either profit from market movements (long volatility) or stability (short volatility). The liquidity-to-volatility engine within Smilee ensures a perfect balance between long and short volatility DVPs, translating Impermanent Loss into unique payoffs. The platform avoids liquidation and counterparty risks while leveraging DEX liquidity for a broad range of assets, providing the levels of customizability and composability.
Smilee vaults enable to easily create any volatility-based payoffs, such as:
Impermanent Gain
Options
Variance Swaps
Certificates and Structured Products
Insurance
Smilee's architecture allows for the creation of diverse DVPs, including Impermanent Gain, options, variance swaps, certificates, structured products, and insurance. This flexibility positions Smilee as a primitive for fully decentralized solutions, differentiating it from protocols relying on centralized counterparts. Smilee aims to empower a new wave of DeFi innovation by offering a decentralized and customizable approach to volatility products.
Smilee's architecture exhibits remarkable flexibility, enabling the development of tailored DVPs for sophisticated applications. Whether designed by a protocol, a DAO, or an institution such as market makers and hedge funds. However, having talked about Impermanent Loss and Volatility, we haven’t covered the Impermanent Gain concept introduced by Smilee. Let’s dive deeper into it.
DVPs with short volatility are those who "pay" a non-permanent loss (or part of it) in exchange for a premium.
DVPs with long volatility are those who pay a premium to "earn" a non-permanent loss (or part of it).
How it works:
Liquidity providers (LPs) in DeFi are exposed to a notorious risk: when markets are volatile, they significantly underperform an equally weighted portfolio (the EW portfolio) - a problem known as the impermanent loss (IL).
The sum of the DVP payoffs of long and short volatility is the sum of the LP payoff and the impermanent loss.
The impermanent loss is just the difference between the EW portfolio payout and the LP payout. If you change the formula, the sum of the DVP payout for long and short volatility is exactly the same as the EW portfolio. This is how it looks like in formula form: EW - LP = IL -> EW = LP + IL
Smilee uses DEX liquidity to support a wide range of assets.
4. Gaining on Impermanent Losses
Impermanent Gain is the opposite of the Impermanent Loss and it is a strategy designed to bet on volatility. So how does it work?
Throughout the auction period, participants enter the Impermanent Gain Vault by paying the premium in USDC, which is calculated to offset the APY of the Real Yield Vault.
Once the auction period concludes, the Impermanent Gain Vault disburses the premium to the Real Yield Vault, gaining access to its liquidity. This liquidity is then utilized to replicate the Hodl portfolio's payoff.
Upon reaching maturity, the Impermanent Loss incurred by the Real Yield Vault is transferred to the Impermanent Gain Vault. This transfer transforms the Impermanent Loss into an effective Impermanent Gain.
To understand the primitive better, let’s take an example.
Anticipating a substantial movement in the price of ETH next week linked to a FED meeting, Bob identifies an opportunity on Smilee. He observes the option to acquire an Impermanent Gain DVP with a notional value of $10,000 for one week, requiring only a 20 USDC investment (equivalent to 500x leverage). Taking advantage of this, he proceeds to deposit 20 USDC into the Impermanent Gain Vault.
According to the breakeven formula:
Bob stands to profit if the price of ETH rises by more than 13% or falls by over 12% within a week. Following a week where the price of ETH declined by 20%, Bob's potential earnings are:
Upon deducting the premium, his Profit and Loss (PnL) amounts to $25.55, reflecting a remarkable +128% Return on Investment (ROI) on his initial premium investment.
The Impermanent Gain product is strategically crafted to optimize capital efficiency while mitigating market risks. With a leverage capacity of up to 500x, Impermanent Gain stands out as one of the most capital-efficient offerings in the DeFi.
Talking about the strategies, the versatility of Smilee vaults extends to the creation of more robust and potent strategies. Examples of these additional strategies include:
Upside Only: Focusing solely on the market's upward movement, doubling the leverage (1000x).
Downside Only: Concentrating exclusively on the market's downward trajectory, doubling the leverage (1000x).
Impermanent Gain positions closely resemble purchasing out-of-the-money put and call options. However, leveraging the capabilities of the Smilee primitive ensures exceptionally competitive pricing and the option of early termination.
Moreover, Impermanent Gain Vaults encompass a substantial inherent leverage that, when taken directionally (e.g., upside-only IG), can outperform even the most extremely leveraged products, such as perpetuals, without the associated risk of liquidation.
5. Team Behind the Protocol
Smilee Finance was created by Dvrs, a Milan-based startup founded with the aim of bringing the next billion users to Web3 through innovative products, as well as helping traditional companies and brands adopt blockchain technology. In addition to launching Smilee, Dvrs has collaborated with traditional and innovative players including Catholic University, Mediolanum, Zakeke and Danone, demonstrating its ability to develop effective and innovative blockchain solutions.
In addition, Dvrs is also involved in two blockchain projects within the Bank of Italy's regulatory sandbox, further demonstrating its commitment to evolving the traditional financial sector towards DeFi solutions. It is thanks to its skills that the startup has already won several awards, including the Uniswap award for blockchain innovation.
Metadato - co-founder of Smilee and ceo of Dvrs, who has been involved in DeFi and fintech since 2017 when he left the world of investment banking to launch LoanXchain, a platform for loan tokenization, whose partners include Deutsche Bank, Mediolanum and the Zurich Stock Exchange (SIX). For his skills, Metadao was included in the Forbes Under 30 list in the field of Finance.
Albiwara - co-founder of Smilee, his extensive background includes a notable tenure at BNP Paribas CIB, where he served as an M&A Associate focusing on structured finance client coverage in the energy sector. His earlier experiences at COIMA SGR S.P.A., Crédit Agricole CIB, Banca IMI, Generali, and Titto & Jacobs showcase his diverse skill set, ranging from global strategy and business development to market research and venture capital analysis.
Larpseidon - Head of Growth for Smilee, coming from an extensive background leading Growth for various web3 companies dating back to 2020—most notably Themis, Immunefi, and Colony.
Gio - Head of Business Development at Smilee. Organizer of ETHMilan, Italy's largest ETH & Web3 conference with more than 1200 worldwide attendees. Co-Founder of Web3Mi, Italy's leading meetup group. Former Growth & BD at Colony, Immunefi.
5. Involved Players
Smilee through its product has been able to attract the attention of Backers such as: Dewhales Capital, Dialectic Capital, Outlier Ventures, Synergis Capital, New Order, Multisig Ventures, Concave Capital, Owl Ventures, Hyperpyra, Yunt Capital as well as individuals such as Marc Zeller, 0xSami, Barry Fried, slappjakke, Darren Camas and other anons. Also Smilee mentions Uniswap and Gelato among the integrators.
Conclusion
In conclusion, Smilee Finance emerges as a pioneering force in the rapidly evolving landscape of Decentralized Finance (DeFi), particularly in the realm of Decentralized Volatility Products (DVPs). The protocol's innovative approach to addressing Impermanent Loss and transforming it into Impermanent Gain demonstrates a commitment to optimizing capital efficiency while mitigating market risks for liquidity providers.
The Smilee Finance protocol distinguishes itself by not only introducing a groundbreaking concept of Impermanent Gain but also by offering a comprehensive suite of DVPs, including options, variance swaps, certificates, structured products, and insurance. This versatility positions Smilee as a fundamental building block for fully decentralized solutions, setting it apart from protocols relying on centralized counterparts.
A notable feature of Smilee is its emphasis on user experience, aiming to simplify the interaction with a complex protocol. By addressing the user interface and experience challenges prevalent in the web3 space, Smilee strives to broaden the user base and make decentralized volatility products accessible to a wider audience.
In summary, Smilee Finance stands at the forefront of DeFi innovation, offering a transformative solution for volatility products, backed by a visionary team and supported by a network of influential backers. As the protocol continues to evolve, it has the potential to usher in a new era of decentralized financial products, making significant contributions to the broader DeFi ecosystem.
Smilee Finance links:
Website | Twitter | Discord | Medium | Providing Liquidity vs Selling Options
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