Not financial advice; this article is intended for research/educational purposes only.
Footnotes are available at the end of the article.
Pending governance approval, Overlay will employ “inverse markets” on the protocol - markets where the “quote” of one unit of an asset will be presented in terms of Overlay’s native token, OVL. For instance, there may be an ETH-OVL market. This will help users to hedge the OVL exposure they may have (because of entering positions on Overlay’s markets), and go long on OVL, if they so wish.
In crypto markets, similar to forex markets, the quote for an asset is generally presented as a market pair - that is, the value of one unit of an asset is quoted in terms of the other. For instance, when an exchange quotes the price of BTC-ETH as 0.05, it represents the price of 1 BTC in ETH terms. Similarly, a USD-EUR quote refers to the value of 1 USD in terms of the Euro.
The first asset in such a market pair (SUSHI in SUSHI-USDC) is called the base asset and the second asset is called the quote asset (USDC in SUSHI-USDC). One unit of the base asset is displayed in terms of the quote asset in a market pair quote.
On popular exchanges (whether centralized or decentralized) with perpetual futures/perps (a form of derivatives dominant in crypto markets), the quote asset for market pairs is generally USD or a USD-pegged stablecoin. Users post collateral in the form of USD (or sometimes in other whitelisted cryptoassets) and build perp positions using this collateral, generally getting paid out in USD for their gains.Âą Thus, usually how it works is that a user posts collateral in the quote asset, and the payout of the profits also occurs in the quote asset.
In future versions of Overlay Protocol, the DAO will probably aim to introduce “inverse markets”. These will be markets where the base asset is any cryptoasset that the DAO chooses to have a market for (presumably beginning with assets with deep liquidity like BTC, ETH, and USDC), and the quote asset is OVL, the native token of Overlay.
These markets will help users hedge out price exposure to OVL on Overlay itself (since OVL is used as collateral on Overlay markets to build positions and is therefore, likely inherently volatile and inclined to some kind of inflation). Users will not require external lending protocols to hedge out their price exposure (though they should be able to do this before the inverse markets launch). Hedging out OVL price exposure would require a user going long on an inverse market.
A user denominating their portfolio in ETH could long the ETH-OVL market to hedge out their OVL price exposure; similarly a user denominating their portfolio in terms of USDC can hedge their OVL exposure by going long on the USDC-OVL market.
For instance, say a user bullish on ETH is longing the ETH-BTC market on Overlay with 5 OVL as collateral. They can hedge their original 5 OVL position (on the ETH-BTC market) by opening a proportional long position on the ETH-OVL market.
Conversely, if a user wants to gain more price exposure to OVL (i.e. they want to long their longs or engage in a “texas hedge”), then they could also do this by going short on an inverse market. A user bullish on OVL can post OVL collateral and simultaneously short an inverse market with or without leverage. Such an approach can lever and multiply their price exposure to OVL.
The front end of the protocol should allow users to enter into this type of hedged position without entering two separate positions.
Inverse markets can help users hedge their naked OVL price exposure while entering positions and can also help users gain more exposure than a 1x spot position. Such markets negate the need to hedge using a lending market or a centralized exchange.
Inverse markets require deep liquidity in order to be manipulation resistant and in line with the vision of Overlay. Thus, it is unlikely that Overlay Protocol will have inverse markets at launch. However, they are a key part of Overlay Protocol and they should be launched in subsequent iterations of Overlay.
[1]Â Except in some cases where exchanges have inverse perpetual markets. Here, the payout is generally in terms of the asset itself, that is the base asset.