An example Piggy

Insurance

SmartPiggies can be used as downside price protection in the depreciation of an asset, said another way, as insurance against the price of something going down. This is typically useful when someone holds an asset that they are not interested in selling. A classic example is if Bob holds Tesla stock and wants to continue to hold the stock, but would like to recoup any losses below a certain price, say the price he initially paid for the stock. Bob is willing to pay a premium to someone to provide this protection. Bob enters into a contract with Carol for this protection. Carol agrees to pay Bob if the price of Tesla stock drops below $100. It is up to Carol to decide how much to charge Bob for guaranteeing these conditions. If Bob is willing to pay the premium to Carol, he has insured his Tesla stock holdings if the price per share goes lower than $100. Of course if Bob does not want to pay the premium, he can shop around for other offers, or forego insurance, or sell the stock outright if he thinks the situation is not in his benefit to hold it.

For a concrete example lets say Ellinore purchases 32 ETH at $500 to stake it. She pays a total of $16,000 for these assets. Ellinore is planning to hold this ETH for quite some time, with the hope of collecting the staking rewards until ETH 2.0 is launched, which could be two years away. Ellinore wants to hold the 32 ETH for at least two years, but also wants to protect her initial purchase cost for the 32 ETH. She is willing to pay someone a premium for insurance that will cover losses incurred if the price of ETH drops below a certain price. Let's say, for example, that Ellinore is not comfortable if the price of ETH drops below $450. She wants to keep the ETH, but does not like the idea of losing more than $50 per ETH or $1600.

Ellinore, then, seeks out some insurance against the price of ETH dropping below $450. Ellinore finds Fran who is willing to provider the insurance. Since Ellinore purchased her 32 ETH, the price of ETH has risen to $600. Fran looks at the price rise, and other factors about the likelihood of ETH falling below $450, and determines a premium for each contract that Ellinore wants to purchase. Fran will agree to insure Ellinore's ETH for $5 per contract. For each contract Ellinore is willing to purchase, she will have to pay Fran an upfront cost of $5 per contract. This will insure Ellinore's initial $16,000 purchase. Ellinore decides that the price is fine, but only decides to cover 30 of her 32 ETH. Ellinore agrees to pay $150 ($5/contract x 30 ETH) for insurance to Fran.

Fran will create a piggy that has $10,000 inside it (max payout), which Ellinore can execute if the price of ETH is below $450, for a duration of 3-months, and charge Ellinore $150 for it. This means Ellinore is covered for 3-months if the price of ETH goes below $450, and Ellinore can recoup up to $10,000.

Because SmartPiggies are peer-to-peer, the back and forth between Ellinore and Fran is a contrived example. Practically, Fran has made many piggies, with different parameters, and put them up for auction. Ellinore sees a piggy that fits her individual circumstance, a piggy that costs $150 to provide protection against the price of ETH going below $450, which expires in 3-months. This piggy will resemble an American Put option, with underlying ETH:USD, strike price $450, expiry three-months, collateralized with $10,000 USDC.

To continue with this example, the price of ETH drops from $600, the price when Fran made the piggy and Ellinore purchased it, to $400. Ellinore doesn't like the price below $450 and decides to execute the piggy, hence break it open and take out some money to offset her loses. Ellinore requests an oracle price, the oracle returns a price of $400. Once that price is received by the SmartPiggies contract, Ellinore or Fran can settle that piggy, in which case the $10,000 USDC held in the piggy is distributed between Ellinore and Fran. The piggy covered 30 ETH at a strike price of $450, therefore 1500 USDC (450-400 x 30) would go to Ellinore as her payout, and the remaining 8500 USDC would return back to Fran. At this point the piggy is settled and can be burned. The agreement between Ellinore and Fran has concluded, completely managed by smart contracts.

Speculation

The opposite scenario can also be provided. If Ellinore thinks the price of ETH is going to the moon, and wants to be compensated if her assertion is proved correct, she can seek out a piggy that pays out if the price of ETH goes above a certain price. Fran is a liquidity provider and makes piggies that payout when the price of ETH is below a certain amount, and also when the price of ETH goes above a certain amount. Fran has made a piggy that pays out if the price of ETH is anywhere above $1000 and auctions them off.

Ellinore sees this piggy that Fran has made and wants to buy it. So she does. The price of ETH goes from $600 to $1500, and when the price is $1500 Ellinore executes the piggy. For this piggy Fran only put in 1000 USDC and Ellinore only covered 1 ETH, which means that Ellinore will get 500 USDC, with the remaining 500 USDC going back to Fran (1500-1000 x 1 = 500). This piggy would resemble an American Call option.

Liquidity Providers

Wow, this seems great for Ellinore, but Fran seems to be losing a lot of money! Well, Fran is pretty smart, and will either charge a high premium for probable payout scenarios or provide piggies that she determines are unlikely to payout. Fran is going to manage her risk in a way to limit frequent large payouts, or else she will be bankrupt very quickly. Over a long time frame Fran is going to make money by charging premiums for her services, which will offset the cost of capital lockup for her depositing the collateral into the piggies. Fran may provide collateral to piggies that payout every now and again, but on average she determines that she will earn more premium from putting collateral into piggies, than putting her money elsewhere, or letting it sit around.

Capped Collateral

(A note about the potential upside and downside loss with regard to collateral held inside SmartPiggies)

SmartPiggies are fully collateralized. This has some advantages as well as some disadvantages that should be considered. For Ellinore this is great news. It limits Ellinore's payout, but it also guarantees that if the piggy pays out, Ellinore will get the proceeds. If Fran has mismanaged her capital, and all of her positions move against her, all of her counterparties holding piggies will get paid. If Fran was fractionally collateralizing her agreements with counterparties, her counterparties would not get their expected payout.

From Fran's perspective, she is dealing with all of the risk, so she is going to charge for it. Being that SmartPiggies are 100% collateralized, Fran can more accurately manage her risk but also incurs a higher cost of capital. Fran has to put her capital in a piggy, and can't get it out until the piggy expires or the counterparty executes it. This means that Fran is going to be looking at a decent return for putting her capital at risk, and for choosing to put them in piggies rather than somewhere else where her funds may make a better return.

SmartPiggies have benefits and costs, but all participants get what they pay for.