As Bitcoin's volatility hits new lows, traders are turning to DeFi and options

Down with DeFi

"This happens, these type of cycles in crypto," said Joshua Lim, head of derivatives at Genesis Global Trading. "Two cycles ago we had the ICO boom. Then we had IEOs and exchange tokens. Now we're seeing the same thing with DeFi governance tokens."

"Traders move from BTC into the trade du jour, and BTC dominance declines," Lim added. 

Indeed, there is bullish momentum behind the nascent market for decentralized finance. More than a billion dollars in total assets have been borrowed using Ethereum-based money market protocol Compound — which some view as the poster child of DeFi — fueled in part by the so-called "yield farming" craze. Yield farming is a catch-all term for generating yield by taking advantage of various non-custodial lending and exchange protocols. On Compound, for instance, users can earn COMP, its recently launched governance token, by lending and borrowing on its platform.

Meanwhile, centralized exchange FTX has seen its DeFi perpetual contract — represents a basket of various decentralized finance coins — appreciate by more than 50% since it launched a month ago.  

Traders are increasingly moving into new DeFi tokens while at the same time de-risking by trimming positions in large-caps like bitcoin or ether, Lim said. Naturally, that is increasing demand for trading in certain tokens, such as COMP and BAL. Lim explained:

"Counterparties that would normally be focused on trading the majors have started to refocus on more frontier assets, where there are larger spreads, more volatility and fewer market makers. Beyond just increased spot OTC volumes in these assets, we're seeing borrow requests for market-making inventory, along with option hedge pricings from traders and investors."

Bobby Cho, co-founder of trading firm CMS, told The Block that it's DeFi's moment to shine, noting that "a lot of money is chasing yield with the broader low volatility. They need to make money somewhere." CMS backed DerivaDEX, a new entrant to the market, in a recent funding round. 

Options in options 

According to Lim, traders are selectively adding risk in a range-bound market by selling options in those large-cap names. The development of the derivatives ecosystem has made it easier for traders to profit from yield opportunities in options.

"There was a time when no one was selling 'volatility' in crypto, and implied vols were priced high to reflect the long-term existential uncertainties of the asset class," he added. "Now there are vol sellers around every corner, supply is abundant. Everyone is using options to generate yield in a quiet market."

In a sense, traders selling volatility reinforces the low volatility regime, according to Lim. 

"The more dealers hold long option inventory, the more actively they delta-hedge on big moves, the more realized volatility gets dampened. Moves are less gappy and one-sided. Then as realized vol declines, dealers get hit on more supply as implied vol follows realized vol. It's a cycle that will continue until we get a sharp break out of this regime."

In certain corners of the market, traders are speculating that large trading firms selling vol is "forcing [bitcoin] back into the $9,200 area," as one exchange executive noted. 

Others — like Cove Markets co-founder Scott Knudsen — said that strangles are commonplace in most markets, adding that it's likely not the only force contributing to the low volatility in bitcoin. 

"You probably have seen some of these stories in the stock market," Knudsen said in a phone call. "Some of these hedge funds have blown up after selling these strangles when the market is moving. These firms were over-levered because they blew through their short strikes. Those have existed forever in every market."