Smilee: The On-Chain Primitive Pioneering Decentralized Volatility Products (DVPs)

March 1, 2024

In conclusion

While crypto bros may disagree on various matters, such as whether Starknet's airdrop distribution model was fair or if farmers have a valid reason to be annoyed when hit with a reverse-uno, two things we can all agree on, regardless of our identities as e-beggars or desired users, are that volatility drives crypto speculation and farmers play an active role in the DeFi ecosystem.

Today, farming is more sophisticated than it used to be, going beyond testnet activity to include retroactive activities that require farmers to indulge in more sophisticated levels of interaction.

For example, a Decentralized application (Dapp) warrants users to provide liquidity to its pools for a specific period if they want to be eligible for a future drop of the protocol’s native tokens. However, unlike seasoned liquidity providers, airdrop farmers who provide liquidity might not understand some of the nuances associated with doing so, for example, Impermanent loss.

Impermanent loss occurs when there’s a change in the price of the deposited asset. For example, airdrop farmer John has to provide liquidity to a newly launched AMM without a token in the hope that he gets an airdrop from the protocol.

John decides to deposit $1,000 worth of ‘Token A’ at a market price of $0.1 per token into the pool alongside a corresponding stablecoin on a 50:50 basis.

Should the price of Token A move upwards to $0.15 per token, the AMM rebalances the pool to maintain an equilibrium between both tokens. On the other hand, John ends up with less Token A and more stablecoin. This loss can be temporary should the price of token A return to the original value while deposited, albeit if it doesn’t, then John ends up losing permanently.

The concept of impermanent loss has been a recurring theme in every iteration of AMM infrastructure since the inception of the constant market-maker model. Although certain models (concentrated liquidity via UniV3) reduce the amount of loss incurred by liquidity providers, LPers have to actively manage positions to ensure that the liquidity stays within range. Otherwise, they’re likely to lose more should the price of the asset move from the range wherein they provided liquidity.

And so, the question arises: If impermanent loss is such a problem, what’s the solution, or at best, what can be built around it?

Thankfully, one of the most interesting things about crypto is how technical debris can quickly become the basis for even more exciting innovations.

In light of the above, we are introducing an interesting rethink and approach to volatility and impermanent losses in crypto by Smilee protocol, changing the landscape through the creation of an on-chain primitive that allows users to trade volatility.

Smilee as an on-chain primitive for DVP trading

Smilee can be described as an on-chain protocol that enables the trading of volatility-based products such as impermanent gain.

However, before the protocol got to its most recent version, there were a few progenitor versions (v0 and v1).

The OG version, Smilee v0, was an Aave-esque fork that was built to turn DEX liquidity into volatility through an Aave-esque lending and borrowing mechanism. The limitations of this approach led to Smilee v1, which is essentially a custom synthetic engine that permits the creation of volatility-based payoffs through mathematics, setting the standard for how Smilee functions today.

Version 1 improvements of the protocol resulted in increased capital efficiency and a more composable version of the protocol (absent in v0) and enabled a flexible approach toward integrating various token types.

The current version (v1.69) introduced a synthetic concentrated liquidity automated market maker (CLAMM), allowing users to buy and sell whenever, as well as introducing directional impermanent gain (long, short, delta-neutral).

These improvements are relative to the two main volatility products of the Smilee protocol:

  • Earn (Real yield)
  • Trade (Impermanent gains)

Real yield

Users provide liquidity to Smilee’s Earn Vaults and earn yield in the form of $USDC. The liquidity provided allows for the minting and trading of impermanent gain. The liquidity provider, in return, earns fees.

But how does this work? Where do the fees come from?

For each Earn vault, there are a pair of tokens, a maturity, a strategy, a fixed rate, and an auction period (a period to deposit liquidity into the Earn vault).

As such, the liquidity provider (LPer) is distinct from the trader. The LPer earns fees from the premiums paid by traders that speculate on the direction of impermanent loss in a pool by depositing into the impermanent gain vault.

Worth noting is the fact that since the fees are generated from premiums, they're actually getting much more fairly compensated than the standard volume fee you see across DeFi that has nothing to do with their IL exposure (volatility). The cumulative premium paid by the traders forms the base APY of the Earn Vault.

Another intriguing side to Smilee's real-yield product is that it doesn't merely function as a typical DEX or AMM; it's actually a bit superior. How so?

Smilee employs a novel design that addresses common issues found in AMMs, such as toxic order flow and Just-In-Time liquidity bots, by equalizing liquidity ranges and fixing time durations for all concentrated liquidity. What this means is that Smilee is MEV-proof, free from Jared and the boys, and completely avoidant of the fuss of manually setting your liquidity ranges.

The process:

  1. Deposit assets to a token pair of your choice.
  2. Earn yield from impermanent gain minting.
  3. Earn yield from impermanent gain trading.
  4. Potentially increase yields through atomic delta hedge — an infrablock component that hedges the delta of LPs for any impermanent gain trade.

It is also imperative to look at two important features of the Smilee system, The synthetic AMM and the liquidity-to-volatility engine, before discussing the second product, trade (impermanent gain).

Smilee Synthetic AMM: Both the earn vault and impermanent gains trading find common ground with the synthetic AMM. The AMM is a conceptual component implemented at the smart contract level and uses liquidity deposited to the vault to facilitate the trading (buying and selling) of impermanent gains before the maturity date. The Synthetic AMM helps determine the correct price to trade impermanent gain using the Black Scholes formula and a combination of Oracle models for price maintenance.

Liquidity-to-volatility Engine: The mechanics of the Liquidity-to-volatility engine account for the synergy between liquidity provider and trader. For each Earn vault, there’s a corresponding impermanent gain. The impermanent loss incurred on the earn vault is tantamount to the payoff for the impermanent gain. Like the synthetic AMM, the liquidity-to-volatility engine is also a conceptual component of the Smilee protocol implemented at the smart contract level.

The Impermanent Gain

The impermanent gain is a Smilee primitive decentralized volatility product (DVP) defined by a reference token and a maturity frequency.

Impermanent gain, although not entirely exact, shares a bit of similarity to options contracts; there is an initial or strike price, which is the current price of the underlying token at the time of purchase, as well as an expiry or maturity period of the contract, which is the date when the final value of the impermanent gain is determined.

Impermanent gain (IG) is represented by ERC721 tokens and are of different types:

  • The IG BULL — In this scenario, the trader is long the underlying asset's price (LP), thereby betting on an upward price movement.
  • The IG Bear - Here, the trader is short the price of the underlying asset (LP), thereby betting on a downward price movement
  • The Smile - Here, the trader bets on a volatile price movement irrespective of the direction. This is achieved by purchasing both IG Bull and IG Bear.

The purchase of impermanent gain positions is done by depositing into the impermanent gain vault, after which an ERC721 is issued to the trader as a representation of the position.

The trader also pays a premium (denominated in USDC) when trading impermanent gains and will lose the premium should the trade go in the opposite direction at the end of the maturity period.

Moreover, in a situation where the impermanent gain is equal to the premium paid, the trader will be at breakeven. A trader profits when the impermanent gain position goes in the right direction of the trade, exceeding the premium paid to score profit at the end of the expiry date.

Trade settlements are done at the end of a maturity period in a reflexive pattern wherein every Earn vault and Trade pair has a maturity frequency: daily, weekly, and monthly, patterned to achieve an overall standardized coherence.

Another interesting feature about the Impermanent Gain DVP is that they are exposed to leverage. Traders can open up to 1000x leveraged positions on any of the three aforementioned directions of volatility.


Aside from the redistribution of premiums paid by impermanent gain traders to liquidity providers, Smilee charges specific fees to the traders.

  • A base fee (fixed amount) paid directly to the vault to cover swap costs.
  • A trade fee, which is a percentage of the notional trade paid to the fee manager which includes fees from the burning of expired positions.
  • A success fee, which is a percentage of a trader’s PnL, is also paid to the fee manager whenever a trader sells an impermanent gain position in profit.

On the other hand, liquidity providers do not pay any fees.

Keeping up with the ecosystem

Smilee’s plans are to eventually evolve into a DAO. However, the protocol understands the importance of being careful enough to avoid unforeseen issues, given that this is an entirely new primitive that builds on one of the bedrocks of crypto: volatility.

To this effect, Smilee will undergo three stages of decentralization:

  • Protocol launch and initial growth: As of the time of writing, Smilee is live on Mainnet on Arbitrum, albeit in a close beta environment.
  • Protocol scaling wherein role-based access control (RBAC) roles will be assigned to the DAO, granting a portion of permissions and privileges to the DAO.
  • Protocol maturity wherein the DAO will be able to renounce all or some RBAC roles and gravitate toward a completely decentralized protocol with immutable smart contracts.

The protocol has also secured an Arbitrum grant for a collaborative top-secret endeavor, to be revealed in due course.

The public launch of the Smilee protocol is scheduled to take place after the Sherlock audit contest, which ends on the 6th of March, 2024.

Concluding thoughts

There's no denying that Smilee is a truly innovative protocol that transforms challenges into opportunities across various user segments.

Notably, it provides an avenue to acquire impermanent gain positions when anticipating volatility in specific asset types. Similarly, it serves as a hedge against impermanent loss exposure for LP positions.

Furthermore, Smilee presents a distinct opportunity to leverage real yields for protocols seeking to integrate with its architecture.

Beyond simply creating these opportunities, Smilee does so within one of the most liquid practices, LPing on-chain, thereby establishing a framework that largely mitigates the liquidity mining dilemma commonly encountered with on-chain Dapps.

As the market continues to heat up, we will be seeing a lot of new entrants, a lot of lost souls, and a hell of a lot of volatility. Smilee is most definitely one product to keep an eye on in the near future.

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