Research paper aims to identify Black-Scholes of DeFi

Identifying the DeFi-equivalent to the Black-Scholes model might be the key to DeFi’s mass adoption, says author

A new crypto research paper, released last week, was aimed at identifying the “Black-Scholes of decentralised finance (DeFi)”. Authored by Guillermo Angeris, Alex Evans and Tarun Chitra, the paper attempted to conceptualise an equation to enable investors and users to accurately value DeFi projects and comprehend potential profit/loss metrics in popular DeFi verticals such as liquidity mining.

Liquidity mining refers to the process of rewarding users with trading fees or governance tokens, often denominated in APY percentages in exchange for providing liquidity to automated market makers like Uniswap.

However, users often suffer from “impermanent losses” due to fluctuations in the demand for a trading pair and a simple APY calculation on a user interface has proven to be insufficient to accurately determine what the gains might look like for liquidity providers. The paper aims to develop a framework to solve this issue.

Titled “When does the tail wag the dog? Curvature and market-making”, the paper states that liquidity mining is best thought of as a complex derivative. One of the authors and the founder and CEO of DeFi risk analysis firm Gauntlet, Tarun Chitra, explained the thought behind the research paper to CoinTelegraph.

“Most passive investment products often have non-trivial derivatives-like exposure. For instance, the collapse of the ETF XIV in February 2018 illustrated how some assets that are passive and safe have complex exposure”, Chitra explained.

“Liquidity providing in AMMs is not so different, although it presents a new set of risks to holders. Liquidity providers are always balancing fees earned (positive income) with large price moves losses (negative, impermanent loss)”, he elaborated.

“Such complexities on the system have caused the failure of liquidity mining projects either due to over-incentivisation or under-incentivisation. Therefore, it is imperative that users and developers think of farming as complex derivatives analog of maker-taker incentives on centralised exchanges”, Chitra stated.

The conceptual model proposed in the paper is aimed at enabling more sophisticated decision making from liquidity providers, while also contributing to a more robust architectural framework for AMM developers.

“APY only makes sense for fixed income assets (bonds), whereas derivative pricing makes MUCH more sense for something like liquidity provision. We hope this is the first in the line of many works that try to find the ‘Black-Scholes of DeFi’”, Chitra explained.

He further added that finding a DeFi-equivalent to the Black-Scholes model might be the key to DeFi’s mass adoption. Black-Scholes was a 1980s model that helped investors find ways to properly price stock options, thus leading to a massive boom in derivatives trading.