- The crypto market has fewer market makers willing to take on risk, resulting in volatile swings in second order parameters.
- Reverse knockouts are attractive options when there is a skew towards the top side.
- Caroline Marone, co-founder of Orbit Markets, discusses her transition from trading FX derivatives to pioneering the crypto exotics market.
- The crypto exotics market offers opportunities for hedging and running similar business models as in traditional investment banks.
- Demand for products such as variance swaps and volatility swaps exists in the crypto market.
- Outsourcing the function of buying vanilla options and delta hedging to dealers can be more efficient and cost-effective.
- There is interest in buying ETH volatility and offering systematic ETH ball swaps.

- The speaker discusses the potential for selling BTC wall swaps due to high BTC volatility compared to ETH volatility.
- They mention interest in spread trading, particularly selling BTC and buying ETH.
- The speaker believes that the market has not fully priced in the implications of the Shanghai upgrade and there may be opportunities for trading.
- They discuss interest in structured note business and exotic options in the crypto market.
- The speaker explains the concept of reverse knockouts and appearing call spreads as ways to cheapen options and express directional views.
- They mention the potential for large upside moves in ETH and BTC and the attractiveness of discounted options in such scenarios.

- The speaker discusses the benefits of using knockouts as a leveraged way to have a positive view on the market.
- They suggest allocating a portion of premium to knockouts for diversification purposes.
- The speaker highlights the attractiveness of knockouts in the crypto market due to the inconsistent pricing of risk reversal.
- They explain the hedging process for knockouts, including the use of spot and vol parameters.
- The primary venue for hedging crypto risk is through derivatives, such as Paradigm.
- The speaker mentions the importance of having a high internalization ratio to reduce fees and market impact.
- The speaker mentions the offering of DeFi exotic options, specifically in hedging impermanent loss in Uniswap liquidity pools.

- The setup of the automated market maker in Uniswap creates short convexity exposure and a defined payoff formula.
- This type of payoff formula is considered an exotic option and can be priced and hedged using standard models.
- There is interest from various funds and individuals in hedging impermanent loss on Uniswap.
- Different approaches to hedging impermanent loss include buying long-term V2 hedges and advanced strategies on V3 liquidity provision.
- Market infrastructure and intermediaries are needed to package and provide hedged liquidity on Uniswap.
- Similar hedging strategies are being explored for staking yields in DeFi.
- Counterparty risk is a concern in the crypto derivative market, but the lack of transparency is a bigger issue.

- Lack of transparency and audited financials in crypto trading makes it difficult to have confidence and take risks.
- Standard setup of exchanging collateral daily based on market to market is effective in reducing risk.
- Decentralized solutions like Gnosis Safe could potentially be a good alternative to custodians.
- Multi-sig wallets could solve the trust issue in bilateral OTC trading and bring benefits like speed of settlement, lower cost, and asset class agnosticism.
- DeFi could be the answer to the challenges in the traditional finance industry.
- There is a need for centralized clearing exchanges or DeFi solutions for complex payoffs.
- Some people are hesitant to take on smart contract risk or C-file credit risk, so both solutions may coexist.
- Trust in well-written code that has been audited is preferred over opaque balance sheets.
- Building the proposed solutions is a good idea and should be pursued.

- The crypto market has fewer market makers, leading to volatile swings in second order parameters.
- Caroline Marone discusses her transition from trading FX derivatives to the crypto exotics market.
- The crypto exotics market offers opportunities for hedging and running similar business models as traditional investment banks.
- Demand exists for products like variance swaps and volatility swaps in the crypto market.
- Outsourcing buying vanilla options and delta hedging to dealers can be more efficient.
- Interest in buying ETH volatility and offering systematic ETH ball swaps.
- Potential for selling BTC wall swaps due to high BTC volatility compared to ETH volatility.
- Interest in spread trading, particularly selling BTC and buying ETH.
- Market may not have fully priced in the implications of the Shanghai upgrade, creating trading opportunities.
- Interest in structured note business and exotic options in the crypto market.
- Use of reverse knockouts and appearing call spreads to cheapen options and express directional views.
- Benefits of using knockouts as a leveraged way to have a positive view on the market.
- Importance of high internalization ratio to reduce fees and market impact.
- Offering of DeFi exotic options for hedging impermanent loss in Uniswap liquidity pools.
- Different approaches to hedging impermanent loss, including advanced strategies on V3 liquidity provision.
- Market infrastructure and intermediaries needed for packaging and providing hedged liquidity on Uniswap.
- Similar hedging strategies being explored for staking yields in DeFi.
- Counterparty risk and lack of transparency are concerns in the crypto derivative market.
- Decentralized solutions like Gnosis Safe and multi-sig wallets could address trust issues in crypto trading.
- Need for centralized clearing exchanges or DeFi solutions for complex payoffs.
- Trust in well-written code and audited smart contracts preferred over opaque balance sheets.
- Building proposed solutions is a recommended course of action.

In this episode, Co-founder of OrBit Markets Caroline Mauron dives deep into crypto exotics and what she sees as the next logical step for crypto derivatives.

TLDR;

1.  Crypto exotics in tradfi wrappers (e.g. barriers, vol/var swaps, worst-of autocallables)
2.  The emergence of crypto-specific exotics that don't exist in tradfi... e.g. impermanence loss swaps for Uniswap LPs & staking swaps
3.  Tackling OTC counterparty risk as an exotics house...multisig wallets as a potential solution.

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All opinions and actions expressed and undertaken by the guest and host are individual opinions and actions only and do not reflect the opinions and actions of Paradigm. Paradigm does not guarantee the accuracy, applicability, reliability, integrity, performance or appropriateness of the content of this video, nor shall Paradigm be liable for any loss or damage that may be caused directly or indirectly by your use of these contents.

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There's less market makers in crypto who are ready to warehouse risk.

And so you see those wild swings in those second order parameters.

And so that makes those reverse knockouts actually even more attractive when that skew is for the top side, when, to be honest, it shouldn't be.

Hi, I'm David Raquel, Director of Sales at Paradigm.

The ball is reverting, so the obvious trade is always the expensive 1

This whole peak inflation, peak rates narrative, peak Fed, which we've been talking about for a while.

The crypto option markets are definitely showing some signs of life.

I'm at Paradigm in the weeds around everything crypto vol markets.

And today I'm joined here by a new paradigm guest to the show Sohan on our sales team in Asia.

Sohan if you just quickly introduce yourself, I think that'd be helpful.

I'm a director of institutional sales out in Asia.

And my background is on the Treadfire side, I come from a structured products background.

So structuring sales, always in effects and rates.

And I moved over to Paradigm about a year and a bit ago.

And today, very, very excited to say that our featured guest is Caroline Marone, co-founder of Orbit Markets in Singapore.

So just to start, if you could just tell us about your background and how you transitioned from trading FX derivatives at Deutsche to now basically pioneering the crypto exo markets at Orbit.

It definitely seems like quite the jump there.

Yeah, so like Joe just said, I spent 13 years at Deutsche Bank, trading mainly trading FX options, quite a bit for exotics.

And I was co-head of the FX trading business for APAC in my last 3 years.

I just kind of wanted to change and do something else.

And I started looking into crypto after that, a few months after that.

And yeah, I thought it was really interesting actually that the crypto vol market was pretty liquid.

I think Drew, you mentioned in 1 of the earlier podcasts that people at JP Morgan don't even know there's a vol market.

Like, I didn't really realize how liquid the vol market was, or that it even existed.

So I took some time off, and I realized all these things, and I got really interested.

And at the same time, I also realized that despite a liquid, fairly liquid vanilla options market, no 1 yet was doing exotics, which are you know, in, obviously, you guys worked in IV, you know, like in the typical options desk, whether that's in equity or in FX or in commodities, exotics and bespoke structure products tend to be quite a large part of the business.

And so we were surprised that no 1 really was doing this in crypto.

So we thought, yeah, that's an opportunity here.

Nobody really knows in TradFi, or not that not too many people know in TradFi, that there's actually a somewhat liquid, you know, vanilla market here.

And because of that liquidity, you can actually, you know, replicate some of these payoffs.

It's quite, quite interesting that, you know, some of these products are being done in short, fine, very emerging currencies or in single stocks that really even in options barely trade, right.

And so in that sense, like crypto options are easily more liquid than some of these things.

So yeah, crypto exotics can can very legitimately be hedged, at least to some extent, and essentially run the same kind of business model as you do in an investment bank.

So just, so typically when we record, you know, the big picture, you know, we discuss the crypto vanilla option flows in the market, macro environment, but giving your crypto exotic lean, I feel like that would be kind of like a wasted opportunity.

And the reality is Paradigm doesn't yet see exotic flows on our platform because all the Paradigm trades are exchange settled, right?

So I do think that today's format should be a little different and we kind of dived into that world of crypto XO.

And just to set the stage for people that might not have too much of a background in exotic derivatives.

So exotic derivatives are types of financial derivatives that have features that are more complex or bespoke than a traditional vanilla option, such as bespoke payout structures, multiple underlying assets such as baskets or unusual expiration dates.

So, yeah, I come from an equity exotics background where a lot of the structures that we were trading, you know, were ones introducing discontinuity risks such as, you know, barriers or binaries or, you know, trading realized volatility or variance in swap formats or, you know, forward starting options, you know, an option that begins a year from now in January 2024, but has like an expiration in January 2025.

So just wanted to set the stage there for viewers.

But in terms of, you know, crypto exo, it's like a fairly young market, but what sort of like products are you seeing demand for?

And what are the sort of structures that tend to the price attractively?

I feel like you've done my job already going through all the products.

Yeah, look, I think maybe 1 product, 1 exotic product that's quite familiar and quite talked about in mainstream news is the variant swap, which is iniquity is known as the VIX.

And that VIX index is very well known, and so people trade those variance swaps in Tradfine.

It's an extremely liquid product, really.

Probably more or similar to vanilla options.

Drew, you probably know better than me for equity, but this is a liquid product.

And so, I'm from FX background, not so much, but still, vol swaps and variance swaps are very common products.

And we've also seen demand for these products in crypto, I think for exactly the same reason as they exist in trad5.

Basically, people have views on whether the market is going to be volatile or not.

And they want to express those views without having to keep changing their position.

If your view is that volatility is going to go up, well, you can buy an option.

That's a good thing to do in the beginning, but then after spot starts moving, then maybe your exposure is not what you wanted it to be.

Suddenly you have a directional exposure rather than a volatility exposure and that's not your view anymore.

So you need to keep rebalancing this thing, maybe sell that option, buy a new option, etc.

Yeah, so let's deep dive into that for our listeners.

Let's say I have a view that volatility is going up.

Traditionally, what I would do is I would just go in and buy a vanilla option and then Delta hedge multiple times as spot is moving.

And as spot moves far away from the strike, then my Vega is less.

And so I have to go in and buy a different option, et cetera.

So you're basically outsourcing that entire function to you.

You just want to, you think volatility goes up, you just buy a so-called volatility swap, and your payout is exactly whatever the volatility ends up being, the realized volatility, minus where you bought it.

So that's a very clean way of taking a view on volatility.

And all the nitty gritty of doing the vanilla option, doing the delta hedges, rebalancing the vanilla options, et cetera, You don't have to worry about that that that's for us to do and that's much more efficient for a dealer to do done for an individual.

Trader, because you know we can aggregate all different positions and and we will have a lot of offset so that we don't need to keep rebalancing each individual position and that will give us economies of scale, whereas if you're doing it for your own position that becomes really expensive, all this rebalancing and rehedging.

So that's 1 example that we've definitely seen demand for this year.

Some people wanted to buy ETH volatility.

I think our friends at Ribbon Finance were actually pitching that idea to buy ETH Ball.

And- Oh, so like a systematic ETH Ball swap.

Yeah, So that it has to be, the loss has to be flown, because you know that basically that sets a maximum loss and that fits into a vault format much better, or into any kind of DeFi format.

And yeah, usually these things are just caps and float it kind of makes the payoff a little bit smoother for for all parties so so we had some interest in that that looked really good historically If you look over the long term, essentially something always happens over a three-month period that, you know, there are some non-volatile periods, but if you look over 3 months, something always ends up happening, so that looks good.

At the same time, I think at the time, like a few weeks ago, the BTC vol versus ETH vol, that looked a little bit like not wide enough.

Like BTC vol was a bit too high as compared to ETH vol if you compare to realized.

So some people were interested to sell the BTC wall swap.

Have you seen like interest in the spread where like, you know, sell BTC by ETH, especially with the Shanghai upgrade, you know, coming now and you know, the massive rally that we had, you know in BTC versus ETH, you know, I could see people kind of looking at that trade.

I think that makes total sense now with the Shanghai upgrade.

I actually think people are maybe like not really paying enough attention because nothing happened on the merge.

And now it's like whatever happens on these chain, you know, it's just non-event.

But yeah, but this 1 actually has like supply and demand effect more so than the merge.

So I think it could be interesting and we've definitely had interest all over that event.

Yeah, I mean just speaking to the vanilla options market, we saw so much interest and demand for premium ahead of the merge.

And so far around the upgrade, as you say, that has much larger supply-demand implications.

We really haven't seen anything yet, right?

Like it could be the case, people are gonna wait until next month to start putting on those views, but as of now, they just really haven't.

There's barely noticeable term structure on the March contract.

Yeah, so it's cheap at the moment, I would say.

Right, and I mean, just like operationally as well, right?

Like there's also just like technology risk that's just not baked in, right?

You know, where something has the potential to go wrong.

So like, okay, so how do you guys see this, you know, the crypto exotic market, you know, evolving going forward?

Like, Are you guys seeing interest from, for example, I come from the equity vol background, we were doing a lot of structured note business, right?

The worst of auto calls out of the Japanese and Korean family offices was quite massive.

So just for the viewers effectively what these structures do is they combine a coupon payment with a short worst of knock and put on a basket of underlies, S&P, Eurostock and Nikkei for example, in equities would be like a very common auto call.

These things would have like a 2 to 4 year maturity and given effectively whoever owned this note had this long covariance exposure on a basket of highly correlated assets.

You could collect some optimally, you know, attractive yields on this stuff, right?

So are you guys starting to see, you know, some demand for that sort of stuff?

It kind of seems like a logical target audience if these guys are kind of looking to collect these juicy yields already in equities.

I mean, hell, what happens when you put a basket of BTC, Ethan?

I mean, let's hope those were, because those would have knocked, right?

Those would have knocked and would have gotten nasty.

Like, have you guys seen any demand for that stuff?

Yeah, I mean, look, it's a bit, I would say it's a bit different from what we see in Tradfai.

Like, in Tradfai, this business is very well, the infrastructure is very well defined.

You know, there's the distribution partner in Japan and Korea and then there's the issuer and then there's the investment bank acting as the swap dealer and so all these things have been happening for 20 years and the process is very well defined and like smooth.

I think that, I mean, we are nowhere near in crypto at the moment of having all that infrastructure in place and all the different roles well set up.

So we're ready to be a dealer in these products.

Yeah, look, I think those products are very complex.

Yeah, I mean, I was literally about to be like, can we talk about something simpler?

I mean, I guess in terms of the way paradigm works, right?

We have a bunch of market makers and then we have a bunch of takers that come in occasionally to express a very directional view.

So these hedge funds or risk takers, they are completely not taking a ball view, right?

They're coming in to do a very specific look, yeet is gonna go to this level, right?

I mean, for those guys, is like something more like first generation exotic, like a knock in knock out type instrument?

I mean, do you offer that to hedge funds?

I think the simpler product and probably the most popular as well is the reverse knockout in terms of the those directional type trades.

So, maybe for those who are not familiar with the product, let's, if you take an example, let's say you think ETH is going to go up between now and end of March, you want to buy an ETH call, but that's quite expensive.

So, okay, you're looking to cheapen it up.

So 1 simple way and common way to do that is to buy a call spread, which people do.

So maybe you buy 31st of March 1700 2100 call spread and a costume, I don't know 5% or something.

And 1 common way to do this is to say, OK, actually, if spot goes over 2,100 at any time during the life of the trade, then I'll get nothing.

So With the call spread, if it's over 2100, your payoff is capped, but you still get something, and it can go up at any time and come back down, et cetera.

But with the reverse knockout, it needs to never go over 2100.

So your view is that it's going to go up, but not quite that much.

And if you have that view, you get a much, you can get the option for much cheaper, about 2%.

I'm throwing numbers like those numbers move around, but you know, that around around that kind of discount, very meaningful discount.

On a similar note, have you guys looked at appearing call spreads?

So you're you're long a vanilla call, and then you're short a further out of the money call with a knock in higher, right?

And but then if you knock in, it just goes to the call spread.

Yeah, yeah, yeah, that's quite common as well.

Yeah, I think the other moment, I would say people seem to prefer the RKO format but yeah I

mean I guess it's a very similar view right it's like it's going to go up but it's not going to go up too much but like

exactly You get something with your setup, Joe.

If it goes way through, you still get something.

Let's say a big client comes in and says, look, I think Shanghai upgrade is going to be a really big event.

But it's really we're not in the right micro environment for it to really roof it.

Right, so as spot goes up, there's going to be a lot of selling pressure because a lot of people suddenly they're not down as much as they used to be, right?

So, for them, the option is like that, as in the 3 things that they can do is either buy a call, right, and then buy a call spread, which they can do on Derivate or another exchange.

And then OTC, they can do an RKO or like an appearing call spread or something like that, which is even more leverage, right?

And you get twice as much, is it like about 50% off?

Like if you, in that example that you just gave?

Yeah, I think usually even a bit more, like people will look to like 60, 70% discount, that sort of thing.

Yeah, the upside skew is so jacked out there, right?

You can really get a lot of discount by selling those strikes.

I mean, look at like the upside realized that ETH or even BTC could potentially have.

I mean, look at the beginning of the year, right?

Like in the equity world, we were doing like a fair amount of these, like on like FXI, for example, or like the Chinese internet names that can just absolutely have like massive moves to the upside because and there was a lot of interest in these structures just because you know you could just get absurd discounts you know that were optically quite attractive.

Yeah I mean I think just on Joe's point right like I actually think it makes a lot of sense, even for those people who think there is gonna be a 40% move, right?

Because in a 40% move, in most cases, people are long cash, long Delta, long vol, like, you know, they have all these alts, which are really pumping at that time.

Look, do you really care that you lost the premium that you bought on this option?

Like, I mean, at that point, you're pretty happy anyway, right?

So it's kind of like a levered way for you to, you know, have the view that it grinds higher.

And I think the way you pitch it is from like a portfolio diversification perspective.

It's like, okay, if you're allocating X amount of cash to just like vanilla calls right now, like why don't we take like 25% of that premium allocation and then throw them in, put them in these knockouts.

That was a very, very common thing, you know, from some of the big traditional asset managers who didn't have such a strong view on path.

I mean, especially with crypto, like how could you, right?

Like, so in order to kind of, you know, reduce that premium outlay and, you know, get exposure or on the same token, get exposure to a higher amount of notional, taking some of that portfolio allocation and putting them into some of these barriers, I think makes a lot of sense.

I think it looks particularly good sometimes in crypto because the skew tends to be not very consistently priced, I would say.

It swings widely from very positive to very negative.

I think there's less market makers in crypto who are ready to warehouse risk.

And so that makes those reverse knockouts actually even more attractive when when that's Q is for the top side when, to be honest, it shouldn't be like, or at least not for the long term, you know so.

It's been like a month or so of doing nothing, right?

Like I think maybe it'd be good to understand exactly how you hedge these instruments.

I mean, I understand it's a model and it's complicated, et cetera.

But like roughly, like how would you hedge this 1700, 2100 RKL when it, if somebody traded it today?

So like usually we would look at it in a kind of portfolio approach.

So, you know, we have lots of different trades and none of them are exactly hedgeable, but then as a portfolio you look at the overall kind of sensitivity to different parameters.

The most obvious parameters are spot and vol, so we would very systematically hedge those, And then you have exposure to other parameter like the skew that we just talked about, the shape of the surface, et cetera.

So this is a bit kind of abstract way of thinking about it.

Basically you have your entire portfolio and you look at your sensitivity and you try to match that.

But if you think about it more like, I guess, granular way, so you just have 1 exotic, you don't have a whole portfolio, then what do you do with that 1 exotic?

Then you definitely have some pretty close hedges.

If you think about a simple European knockout, so the product I described earlier, the knockout is so-called continuous, meaning it's observed from the trade date all the way to the expiry any time.

But maybe a simpler product to hedge is what's called a European knockout, where you only observe the knockout at the end, on the expiry date.

So those products can theoretically be hedged exactly.

You know, you have to buy the vanilla strike like the 1700.

And then for the 2100 digital, you have to do a call spread around it to hedge and the tighter the call spread, the better the hedge.

In transfi or OTC, you can do as tight a call spread as people will quote it in a listed exchange market, then you're restricted to whatever are the listed strikes around it.

So the hedge are not gonna be perfect, but if you did like 1700, 2100, 2200 type fly and then you kind of match the nationals to be roughly there, that will be a pretty good hedge to a European knockout.

Now for the continuous knockout, that's a bit different.

Because, well, if spot goes up very quickly, you know, you can put on your static hedge like I just described, but then spot goes through very quickly, 2100 knocks out, then the option is gone.

The exotic option, that option has nothing left, doesn't exist anymore, then you need to unwind your hedges.

So you don't want to be putting on very exact hedges, you know, that maybe you won't need.

So there's like some probability adjustment in terms of what exactly you should be hedging or how much you should be hedging and what ratio of it that comes from pricing models.

Yeah, I think it would be interesting to know how much, like when you hedge, because all of this is OTC, right?

So you're directly facing, you know, like a hedge fund or some kind of risk taker, and they buy this option from you.

So when they trade against you, it's OTC.

But then when you hedge in general, do you use the OTC market or the exchange market to hedge?

No, for, look, if we have any risk that we need to hedge, the primary venue in crypto is clearly a derivative, like including via paradigm.

Obviously you guys are like the top venue to find equity.

So the question is more, how much do you need to hedge?

You know, if like when I when I worked at banks in trial 5, people talk about something called the internalization ratio, which is if a client does 100 of something, how much do you need to actually go and hedge outside and how much can you internalize.

And the target is to have as high as possible an internalization ratio.

You know, banks like in the spot market, they will target 98, 99, 99 point something percent.

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TBP | OrBit Markets Co-Founder Caroline Mauron Explains why Crypto needs Exotics -Ep. 14