Replicating Portfolios: Constructing Permissionless Derivatives

TL;DR

This paper introduces a novel on-chain derivative mechanism using Replicating Market Makers (RMMs) that eliminates reliance on external oracles, enabling trust-minimized structured products in DeFi.

Contribution

It presents RMM-01, the first on-chain expiring option relying on arbitrage, and frameworks for creating various derivatives without external oracles.

Findings

RMM-01 successfully replicates Black-Scholes covered call payoffs.

Structured products can be built on-chain with minimized trust dependencies.

Elimination of liquidation risk in lending markets through new procedures.

Abstract

The current design space of derivatives in Decentralized Finance (DeFi) relies heavily on oracle systems. Replicating market makers (RMMs) provide a mechanism for converting specific payoff functions to an associated Constant Function Market Makers (CFMMs). We leverage RMMs to replicate the approximate payoff of a Black-Scholes covered call option. RMM-01 is the first implementation of an on-chain expiring option mechanism that relies on arbitrage rather than an external oracle for price. We provide frameworks for derivative instruments and structured products achievable on-chain without relying on oracles. We construct long and binary options and briefly discuss perpetual covered call strategies commonly referred to as "theta vaults." Moreover, we introduce a procedure to eliminate liquidation risk in lending markets. The results suggest that CFMMs are essential for structured product design with minimized trust dependencies.