What is Lyra Finance (LYRA)

Introduction

The embryonic stages of on-chain options projects emerged at the beginning of 2020, with most operating in the form of on-chain insurance until the official launch of options protocols such as Opyn v1 and Hegic in the second half of the year, heralding a period of development for the field.

On-chain options markets can be broadly categorized into order book and liquidity pool types based on their trading models. The original options markets adopted an order book model, but due to frequent on-chain interactions and low liquidity, a pool-to-pool trading model was applied to the options market. In this model, the liquidity providers of the pool act as counterparties, with users trading with the pool. While this model alleviates liquidity issues to some extent, it also leads to a situation where the premium income of LPs may not compensate for the losses resulting from price fluctuations of the underlying asset and the exercise of options by the buyer.

Currently, most projects on the market still employ the liquidity pool model, innovating on product yield and swap costs. The core principle remains to balance the gains of both buyers and sellers while attracting market makers to provide sufficient liquidity for the platform.

Lyra Finance is precisely such an on-chain options market employing the AMM liquidity pool model, straddling the two major ecosystems of Optimism and Arbitrum, currently boasting significant liquidity in a leading position in the field. This article will elucidate the operational logic and pricing mechanisms behind the Lyra Finance product, the risk management mechanisms introduced for LPs, and provide an overview of the token model and current developments.

Overview of Lyra Finance

Lyra Finance is a product of the Synthetix ecosystem, a synthetic asset protocol, and it is the first option AMM trading platform deployed on Optimism. In early 2023, it was also rolled out on Arbitrum. Currently, the official website only supports two options for underlying assets, ETH and BTC. The protocol has set up ETH and BTC vaults on Arbitrum, and sETH and sBTC vaults on Optimism.

Source: https://chainslab.io/what-is-lyra-finance

Lyra Finance operates as an on-chain options trading platform following a peer-to-pool model. Liquidity providers (LPs) deposit base assets into the Market Maker Vault (MMV) to provide liquidity. Users can then purchase or sell call or put options from the MMV. As European-style options are traded, the buyer can only exercise the option on the expiration date, with cash settlement employed. Essentially, LPs play the role of the counterparty in options trading, bearing the risk associated with being the counterparty of options. In return, LPs receive trading fee compensation.

Pricing Mechanism

The Black-Scholes model is the most widely applied in option pricing. In comparison with spot and loan products, the on-chain option pricing entails many complex calculation formulas. The performance restrictions of L1 have hindered its progress. Consequently, the Lyra team chose to deploy on Optimism and Arbitrum, two prominent L2 chains and launched the Lyra AMM model based on the Black-Scholes model.

The cornerstone of Black-Scholes pricing is the determination of implied volatility (IV). In essence, trading options is trading IV, and the higher the implied volatility, the higher the option’s price. The Lyra AMM model is fundamentally based on implied volatility, adjusting the value of IV to affect the price of the option. The AMM model adjusts the actual implied volatility of the transaction in real-time according to market supply and demand, thereby adjusting the option price; it increases implied volatility when option demand is high, and reduces it otherwise.

In the Lyra AMM model, the implied volatility (trade Vol) is the product of two parameters: base IV and skewRatio. The base IV is determined by the expiration date, while the skewRatio is dictated by the exercise price.

The protocol obtains the implied volatility value from Deribit through the Chainlink oracle. Initially, the IV values in both options trading platforms are identical, that is, the base IV value is equal to the implied volatility on the Deribit platform. However, when the market undergoes trading, the smart contract adjusts the values of base IV and skewRatio based on the quantity of options contracts traded by users. The trade Vol value calculated by the product of the two is input into the Black-Scholes model to compute the current transaction price.

The Lyra AMM model adjusts the size of implied volatility based on market supply and demand, thereby adjusting the option price. This approach can balance naked positions to a certain extent, preventing the emergence of strong bullish or bearish sentiment, and thus reducing the risk of losses faced by liquidity providers.

Delta Risk Neutrality

Delta is a crucial indicator in measuring the risk between buyers and sellers of options, indicating the sensitivity of option prices to changes in underlying asset prices. Delta hedging is the most widely used option risk management strategy in the market today. Essentially, it involves holding a position in the underlying asset while selling the option, so that the Delta of the two offsets each other, making the overall asset’s Delta zero. To hedge the position risk faced by LPs as passive counterparties of option combinations, Lyra Finance integrates the Synthetix Protocol and GMX to achieve a risk exposure for LPs that is nearly Delta neutral.

Users can directly access the Synthetix and GMX trading platforms through the Lyra official website. LPs first calculate their Delta risk exposure on Lyra. If they are on the Optimism network, they can actively open spot hedging orders on the Synthetix platform; if they are on Arbitrum, they can open long or short futures positions on the GMX platform to hedge.

Vega Dynamic Fees

To balance the naked positions in the market and to shield Liquidity Providers (LPs) from the risk of damage due to excessive one-sided positions, the protocol has launched a dynamic fee mechanism based on Vega.

Vega is one of the parameters that measure the risk of option prices, it gauges the magnitude of option price movements when volatility changes, reflecting the sensitivity of option prices to implied volatility. In the Lyra AMM liquidity pool, LPs are exposed to various Vega risk exposures due to the behavior of users trading options. The protocol maintains Vega’s neutrality through dynamic fees. The core principle is that contracts will charge lower fees for transactions that favor AMM Vega neutrality, and higher fees for transactions that increase the Vega value, thereby balancing long and short positions.

When a transaction occurs, the smart contract calculates the net Vega value of the transaction relative to the AMM liquidity pool, and converts it into a percentage form, referred to as the “Vega Utilization.” Multiplying this with the Vega Fee Coefficient parameter gives the current Vega dynamic fee. This parameter is proportional to the spot price size of the underlying asset – riskier and less liquid assets will consequently have higher Vega fee coefficients.

Risk Management

For traders, the protocol stipulates that users are allowed to trade options with expiry times of less than 12 hours. It also prevents trading of options with a Delta beyond the prescribed limit for the given asset. The only mechanism to close these two types of options is ForceClose, which requires payment of a penalty.

As for Liquidity Providers (LPs), adding or withdrawing liquidity from the Market Maker Vault (MMV) necessitates a cooling-off period of three days, and a fee of 0.3% is charged for withdrawing liquidity.

To mitigate the risks faced by existing LPs, the protocol has introduced a variety of mechanisms:

• Liquidity Circuit Breaker: This ensures that 5% of the net asset value in the liquidity pool is available for trading. If this mechanism is triggered, deposits and withdrawals will be suspended for three days.
• Volatility Circuit Breaker: This is triggered when the volatility of the underlying asset is too high to trade, ensuring option prices remain close to market value. Upon activation, deposits and withdrawals will be paused for 1.5 days.
• Smart Contract Adjustment Circuit Breaker: All trading activities are suspended during smart contract adjustments, and only resume once adjustments have concluded.

To prevent extended capital freezes caused by circuit breakers, Lyra has introduced a guardian organization. This entity consists of two core contributors and five council members, making a total of seven members. They have the authority to manually approve the initiation of deposits and withdrawals through multi-signature authorizations.

Token Model

LYRA is the governance token for the Lyra Finance protocol. It facilitates the election of five representatives who form the council to participate in all decisions related to the protocol, with the representative body being refreshed every four months.

The total supply of LYRA is set at 1 billion tokens, of which 50% is allocated to the community. This includes traders, Liquidity Providers (LP), SNX stakers, security module stakers, those incentivized by LYRA liquidity, and community incentives. 20% of the supply is allocated to LyraDAO, 20% is given to the team, and the remaining 10% is sold to private investors.

Source: https://docs.lyra.finance/governance/lyra-token

The team initiated the Ignition liquidity mining event in October 2021, which ran for six weeks. It aimed to distribute 5.4% of the total token supply to traders, LPs, and SNX stakers. The team also announced the first LYRA token airdrop event on December 14. Early community members and participants of the Ignition event were eligible for airdrop rewards. About 67 million LYRA tokens were airdropped, which accounts for 6.7% of the total supply, with 8 million LYRA being distributed among community members.

Source: https://blog.lyra.finance/an-optimistic-launch-for-lyra/

To attract capital and users, the team introduced a series of reward activities:

• Staking Rewards: Users can earn stkLYRA by staking LYRA tokens. There is a 14-day cooling-off period during which no rewards can be earned. stkLYRA holders can receive annual LYRA staking rewards proportionate to their holdings, with the total reward determined by the council. Currently, the annual reward is 1500 LYRA. Holding stkLYRA not only boosts Vault rewards but also offers trading discounts. The discount increases with the amount of stkLYRA held, up to a maximum of 60%. Staking rewards are distributed every two weeks after a 182-day lockup period.
• Liquidity Rewards: Users who add sUSD liquidity to the Lyra Market Maker Vault (MMV) can earn LYRA or OP rewards, which are distributed biweekly. Users who add liquidity to the LYRA/ETH pool on Uniswap v3 will also receive corresponding rewards. The team annually awards 10 million LYRA for this purpose, with reward parameters decided by council votes.
• Trading Rewards: Recently introduced incentive measures are expected to last twelve weeks, with each two-week period being an Epoch. Each Epoch has an estimated total reward of $150,000 and currently, we are in Epoch1. The event uses a scoring system, and at the end of each Epoch, rewards are distributed proportionally based on each account’s score. Accounts with higher trading fees, shorter expiry dates, and positions at maturity stand a chance to earn more rewards. Additionally, users can enhance their rewards by staking LYRA tokens, being active traders, or being referred by another trader.

Current Developments

Lyra Finance, straddling both Optimism and Arbitrum, two prominent ecosystems, has emerged as the platform boasting the most substantial liquidity in options trading. The platform currently locks around 30 million dollars in total value and has achieved a trading volume as high as 1.2 billion dollars, primarily concentrated in the Arbitrum ecosystem. As an underlying derivatives protocol on L2, Lyra optimizes the composability of DeFi, integrating protocols such as GMX and Kwenta, thereby providing professional investors with a broader spectrum of investment strategies.

The iterations of new versions and the incentives offered through OP tokens have indeed brought additional capital and users to the protocol. Still, the expansion of liquidity does not compare with the effects generated by the LYRA airdrop. The protocol announced its deployment in the Arbitrum ecosystem in February this year. The market’s enthusiasm and the incentive of the ARB token airdrop have spurred an increase in the total locked value.

Source: https://app.lyra.finance/#/vaults

The team has carried out both trade reward and liquidity mining activities in both ecosystems. The initiatives have had a certain incentivizing effect, leading to consistent growth in both capital and user base.

Source:https://stats.lyra.finance/

Source:https://stats.lyra.finance/optimism

Conclusion

Lyra Finance is an options trading platform that operates on a peer-to-pool model. Liquidity Providers (LPs) are compelled to act as counterparties to an options trading pool, acquiring transaction fee revenues while concurrently bearing corresponding position risks. The platform has introduced a Vega dynamic fee and related circuit breaker mechanisms to manage LP risks, and has integrated with the Synthetix and GMX protocols. This allows LPs to open their own hedging orders, bringing LP risk exposure closer to delta neutrality.

Spanning across both Optimism and Arbitrum blockchains is one of the platform’s strengths. At the same time, the team has launched incentives such as trading rewards, staking rewards, and liquidity rewards to attract capital and users. While the short-term effects are noticeable, a potential cooling off of Layer 2 (L2) hype and the end of incentive campaigns may lead to a sudden decrease in liquidity. Furthermore, in the DeFi options sector, structured products are currently dominant, leaving on-chain options trading markets with a relatively smaller market share. Consequently, Lyra Finance may face certain challenges in its future development.