On-Chain Price Discovery: From Identity-Based Lending to Polymarket Arbitrage
I spent most of 2025 obsessing over a single question: How do you discover prices on-chain for things that traditional finance takes for granted?
In TradFi, interest rates have the Fed. Options have the CBOE. Credit scores have Equifax. In DeFi, we have liquidity pools, oracles, and — sometimes — nothing at all. This is the story of three projects that each tried to answer a piece of that puzzle, and how each one’s unanswered questions led to the next.
Chapter 1: Humane Bank — Can Identity Replace Collateral?
The first project started with a contradiction at the heart of DeFi lending: overcollateralization.
On Aave or Compound, you deposit 100 in USDC. It works, but it’s capital-inefficient and excludes anyone who doesn’t already have more money than they need to borrow. Traditional finance solved this decades ago with credit scores — but credit scores require identity, and DeFi is pseudonymous by design.
Humane Bank was an attempt to bridge that gap. The core idea: use a privacy-preserving identity layer (specifically Worldcoin’s nullifier hashes) to create reputation-based incentives for on-chain lending.
A nullifier hash proves you’re a unique human without revealing who you are. If a borrower defaults on an undercollateralized loan, their nullifier gets flagged — not their name, not their wallet, just their proof of personhood. Future lending protocols can check: “Has this human defaulted before?” without knowing anything else about them.
The incentive structure becomes: behave well and your access to cheap credit improves. Behave adversely and your pseudonymous reputation suffers. No doxxing. No centralized credit bureau. Just cryptographic consequences.
But building this system forced me to confront a question I couldn’t answer: What interest rate do you charge on an undercollateralized on-chain loan?
In TradFi, the answer involves SOFR, credit spreads, and decades of actuarial data. On-chain? There’s no benchmark. No risk-free rate. No yield curve.
That question killed the project as a product — and gave birth to the next one.
Chapter 2: Depth Hook — Extracting Interest Rates from Swaps
If on-chain lending protocols can’t agree on an interest rate, maybe the market can discover one organically. That was the thesis behind Depth Hook, a Uniswap v4 hook designed to extract implied interest rates from swap activity.
The mechanism was conceptually simple:
- Create a pool where you can swap an asset today for a claim on that same asset in the future (a zero-coupon bond, essentially).
- The relative price between the spot asset and the future claim implies a discount rate.
- That discount rate is the interest rate — discovered by the market, not set by governance.
For example: if 1 ETH-now trades for 0.95 ETH-in-6-months in the pool, the implied annualized rate is roughly 10.5%. No committee decided that. Liquidity providers and traders arrived at it through supply and demand.
Uniswap v4’s hook architecture made this possible without forking the entire AMM. The hook intercepted swaps to enforce the time dimension — ensuring that the “future ETH” token was only redeemable after the maturity date, while the pool’s native price discovery mechanism handled the rest.
What I learned: Markets are remarkably good at pricing time — even on-chain, even with thin liquidity. The pool found equilibrium faster than I expected.
What I couldn’t solve: Bootstrapping liquidity. A time-based swap pool is a chicken-and-egg problem: LPs won’t provide liquidity without volume, and traders won’t come without liquidity. The theoretical framework was sound. The go-to-market was not.
But the project planted a seed: if you can extract implied interest rates from on-chain swaps, what else can you extract?
Chapter 3: Ultramar Capital — Polymarket as an Options Market
Here’s where things got interesting.
I was studying prediction markets — specifically Polymarket — when I noticed something: prediction market outcomes look a lot like binary options.
A Polymarket contract that pays 5,000 by December” and 5,000 and a December expiry.
Binary options happen to be one of the well-studied derivatives under the Black-Scholes-Merton (BSM) framework. The pricing formula for a cash-or-nothing binary call is:
Where depends on the spot price, strike price, risk-free rate, time to expiry, and — critically — implied volatility.
This opened up a theoretical arbitrage:
- Find matching instruments: Identify Polymarket contracts whose strike prices and expiries align with traditional options markets (or other DeFi derivatives protocols).
- Extract implied volatility: If you have the market price of the Polymarket contract and the BSM formula, you can solve backwards for implied volatility — just like options traders do with the VIX.
- Compare prices: Use the extracted IV to price the same payoff structure on both venues. If the Polymarket price diverges significantly from the BSM theoretical price, there’s a potential arbitrage.
- Construct replicating portfolios: Build a portfolio of Polymarket positions that statistically replicates a traditional option payoff, and vice versa. Profit from the convergence.
What Works
The theoretical framework holds. Binary option pricing under BSM is well-understood. Polymarket contracts with clear, quantifiable outcomes (price thresholds, dates) map cleanly to the model. And because both venues are observable in real-time, price discrepancies can be detected programmatically.
What Breaks
Implied volatility extraction is fragile. In TradFi, you derive IV from a dense options chain with dozens of strikes and expiries. On Polymarket, you might have one contract at one strike. That’s not a volatility surface — it’s a single data point. Extrapolating from it requires strong assumptions that the market may not justify.
Liquidity asymmetry. Even when a theoretical arbitrage exists, executing it requires sufficient liquidity on both legs simultaneously. Polymarket and centralized exchanges have very different depth profiles. Slippage can eat the entire edge.
Settlement risk. Polymarket resolves based on oracle outcomes. Traditional options settle based on exchange prices. If the oracle and the exchange disagree on whether ETH hit $5,000, your “risk-free” arbitrage has basis risk.
The Real Insight
The value of Ultramar wasn’t in the bot — it was in the mental model. Prediction markets, DeFi options, and traditional derivatives are all answering the same question: What is the market’s probabilistic expectation of a future event?
They just express the answer in different languages. BSM speaks in implied volatility. Polymarket speaks in probabilities. Uniswap speaks in price ratios. Learning to translate between them is the real skill.
The Common Thread
Each project failed as a business but succeeded as education:
- Humane Bank taught me that identity and credit are inseparable — even in “trustless” systems.
- Depth Hook taught me that markets discover prices better than committees, but only with liquidity.
- Ultramar Capital taught me that arbitrage is easy in theory and humbling in practice.
The throughline is price discovery — the mechanism by which markets agree on what something is worth. In TradFi, this infrastructure is invisible because it’s been built over centuries. In DeFi, we’re building it from scratch, in public, in real-time.
That’s what makes it exciting. And that’s why I’ll probably spend 2026 thinking about the same question.
Diego Jiménez Vergara — AI Infrastructure & DevOps Engineer. Building at the intersection of FinTech, Quantitative Finance, and Decentralized Systems.