In traditional options markets, options must be sold by a writer who collects the premium from the buyer and who is responsible for paying the buyer if the option is exercised in the money. As an options protocol on Avalanche, Arrow Markets will give users the ability to buy options without the need to be matched with such a counterparty.
Arrow Markets is a global project with backers from New York, Silicon Valley, Singapore, Hong Kong, Dubai and London, including Framework Ventures, Alameda Ventures, QCP Soteria, DeFi Capital, RenGen, CMS Holdings, Avalanche Foundation, and Delphi Digital Ventures.
Arrow will enable end users to interact with DFMs (decentralized financial markets) constructed around arbitrary crypto underliers, such as BTC, ETH, and AVAX. DFMs facilitate the creation and settlement of options, and allow users to create customized assets by combining options across strikes, expiration and underliers.
The Arrow platform is inspired in part by Nobel laureate economists Kenneth Arrow and Gerard Debreu, who showed that prices of financial assets can be reduced to prices of a core set of contracts called Arrow-Debreu securities. In a similar vein, options contracts form a basis for the prices of financial assets, making it possible to construct a rich variety of derivatives and structured products.
The platform works by coupling a decentralized aggregate counterparty (DAC) - responsible for settlement - with an option factory. Coupling the DAC with its option factory gives us a decentralized financial market (DFM). The DAC and the option factory can run on Ethereum Virtual Machine (EVM) compatible blockchains.
Option prices on the Arrow platform are quoted by a contingent claims automatic market maker (CCAMM), allowing users to buy or sell options without the need to be matched with other market participants. The Arrow CCAMMs make use of off-chain resources, allowing for more sophisticated forecasting and pricing computations than can be done on-chain.
The scope for creating financial products on top of Arrow markets is vast. For example, products such as covered calls, variance swaps, and different types of option spreads can be constructed in a composable manner on Arrow markets. In addition, users will be able to vote in a DAO to decide on creating new markets on proposed underliers.
The AMM described above collects premiums from users into a collateral pool. Prices set by the CCAMM account for how each newly written option contract changes the risk profile of the DFM. This ensures that the probability of the (primary) collateral pool going insolvent is minimized.
In the unlikely event that the collateral pool goes insolvent when the option payouts come due, a secondary tail pool is designed to fund its shortfalls. Liquidity providers who fund the tail pool are incentivized with commensurate yields. Coupling the collateral pool with the tail pool ensures that the overall probability of insolvency is kept negligible.
Arrow Markets solves the problem of creating reliably settled financial claims on any outcome with very little overhead. For example, one can create and cash settled options on reference assets such as AVAX, ETH and BTC. The pricing mechanism is sufficiently general to handle mid-tier token underliers, and is sufficiently modular to handle other verifiable outcomes like damage claims for insurance contracts.