As the DeFi revolution continues, we’re first going to see the introduction of tools like those in more mature markets, then we’ll watch as those tools adapt to the specific needs of DeFi.
One of the DeFi tools still in its infancy are volatility measures, but a new company is working hard to improve its sophistication and impact by combining decentralized autonomous organizations (DAOs) and oracles. Volatility Group recently introduced its DAOracle, which applies the governance mechanism of DAOs to an oracle solution, which are conduits for bringing off-chain data to a deterministic blockchain. They believe the DAOracle provides more clarity and reliability, thereby solving the problem of data validity.
The DAOracle has been added to Volatility Group’s crypto volatility index feed, a move that allows it to verify on-chain and publish robust and composable volatility data feeds that can be used to build and inform decentralized financial products and trading strategies. The DAO approves the methodology and its implementation to ensure the transparency, trustlessness, and verifiability of an index. A community-governed rewards pool adds economic incentives to request complex index values and post them on-chain. They are managed by a single smart contract, so transactions can happen automatically, thereby reducing gas costs.
Co-founder Wade Kimbrough has a background in consulting for organizations like the World Bank and governmental groups. He designed games and play-based simulations which informed clients’ research and governance practices. Kimbrough was first introduced to cryptocurrencies in 2013 and met future Volatility Group co-founder Chris Cashwell at an Ethereum hackathon in 2018. The two kept in touch, and after renewing acquaintances last fall they decided to found the company.
Derivatives specialist Razvan Popescu previously worked on Wall Street, where he traded various volatility-informed instruments with a focus on emerging markets. He said he found the transition to cryptocurrency an easy one, as it is the ultimate emerging market.
Volatility Group was founded during an interesting period for cryptocurrencies, especially in the US market, Kimbrough said. Increased attention and criticism from American regulators brought stress to the markets. He said options for calculating volatility were limited, with Ethereum and Bitcoin the only systems robust enough to foster those in-depth calculations.
“It’s very difficult to get good volatility measures for all the different altcoins or all the different ERC-20 coins on Ethereum,” Kimbrough said.
Another issue impacting the sector is the opacity of closed source code and even the methodologies used by some developers, which runs counter to DeFi’s ethos, he added. Adoption is hindered by not knowing what’s under the hood and that hinders trust of what is brought on-chain.
The group joined forces with Peter Hinton, a professor at the University of North Carolina at Chapel Hill who specialized in modeling realized volatility from high-frequency trading. Their upcoming realized volatility measures can be applied to all different types of tokens.
In their bid to provide strong transparency Volatility Group studied different types of oracle solutions before zeroing in on Universal Market Access. Their Optimistic Oracle uses game theory to bring more complex calculations on chain. The two companies are working together to resolve issues with the Optimistic Oracle around bringing in data frequently enough and at a low enough latency for it to be an index.
“We’re really interested in getting volatility indices on chain and this is what this DAOracle is,” Kimbrough explained. “It basically builds on top of their existing infrastructure. It’s another layer of infrastructure that we’re composing on top of it to bring all sorts of volatility indices on chain.”
Popescu said this can provide added value to traders. Indices, rates, anything that can improve returns for traders will be highly valued.
The Opportunity Offered From Periodicity
Some classical models don’t work with cryptocurrencies due to the concept of periodicity, Kimbrough explained. There are predictable patterns of volatility and realized prices on cryptocurrency on both centralized and decentralized exchanges. Commonly used models in traditional finance are based on daily returns, but cryptocurrency markets run 24 hours a day, so results will depend on when traders start and stop each day.
“Your returns each day will depend on that periodicity,” Kimbrough said. “We’re seeing these patterns within days of the week, within minutes of their hour and within seconds of the hour.”
While some have looked at days of the week, there has been no research into minutes or seconds of the hours yet, Kimbrough said.
If you identify those patterns, you can profit from them, Popescu added. Market makers see that and price accordingly when there is alpha to be captured.
“Any little edge that can be provided by a pattern or anything clearly identified can allow you to profit,” he said.
Repeat these small but positive behaviors several times each day and the returns begin to accrue.
Volatility Group is also looking at more novel use cases that can only be used in DeFi where compliant, Kimbrough said. Perhaps you want to write some of these concepts into a smart contract in order to rebalance a capital pool. Add in the right information and you can remove predictable issues which can become problematic.
“You want the volatility to be a random walk but still measure the volatility at that point in time,” Kimbrough said. “You can apply a filter to your GARCH models (which describe financial markets in which volatility can change), and that’s the piece we’re working on and adding in.”
Popescu reiterated his analogy comparing cryptocurrencies to emerging markets, which themselves also bring major opportunities and major busts. An exciting project comes along and causes the company’s price to soar. People get excited, leverages get built but then comes the bust. And in crypto the highs have been very high while the lows have sunk very low.
“The environment itself I think is the most exciting and most incredibly dynamic one where innovation is happening at a pace that is just mind boggling,” Popescu said. “Look at the level of interest and usage and it’s higher than the Internet was in the 90s.
“We’re in the very early stages and with a little bit of support from the government as far as the regulation this could have enormous implications and the growth potential is beyond anybody’s expectations.”
That government support can begin by providing some positional clarity they said. Asset classes don’t like uncertainty. Participants can adapt to strong regulation and if it is introduced in a proper fashion it will foster innovation and the markets will skyrocket they said.
Some believe the world is waiting on the United States to provide the regulatory clarity the entire industry needs in order to flourish. It is too big and important and once the country stakes its position others will react accordingly. While the United States does indeed have significant influence, the cryptocurrency space is a global one, Popescu cautioned. Plenty of regions are taking a leadership role, and capital will move like water to the area offering the lowest impediment.
Kimbrough said Volatility Group is taking a strong approach to compliance, and they believe that prudence will pay off.
On a global front, cryptocurrencies are benefiting from a world awash in stimulus, Popescu added. People and markets realize the situation is completely unsustainable and they need to find an alternative that not only provides safety but also optionality and potential for growth.
“I think crypto comes along as a natural alternative and it’s not surprising that all the cryptos rocketed in March of 2020 when the Fed decided that they’re going to print $4 trillion,” he concluded.