Risk Management for LPs
Last updated
Last updated
With risk management being a key factor for liquidity providers in DeFi, aiPX will use user-elected credit exposure for aiPX's liquidity providers. Originally developed by Level Finance, the RMLP aims to improve issues found within current zero-price impact decentralized perpetuals trading. The creditor structure is commonly found in traditional finance markets, but has yet to see widespread adoption within DeFi. Within the RMLP system are Tranches with varying risk profiles associated with them, reflecting underlying exposure for aiPX Liquidity Providers (ALPs), isolating risk associated with providing liquidity. What is a Tranche? "A Tranche has become a popularized financial term in traditional finance, most frequently in the context of mortgage-backed securities (MBS). Tranches are essentially pieces of a pooled collection of securities that are split up by risk in order to be marketable to investors with different risk appetites. Tranches usually range from the lowest-risk (AAA) super senior on the top of the credit structure, to the highest rewards (BB and lower)." - Level Finance
To adapt this system for DeFi, each tranche represents a pool of assets such as BTC, ETH, MATIC, UNI and stablecoins. With each tranche representing a different risk profile, ALPs are able to choose the amount of risk they are willing to bear. aiPX offers 3 tranches for ALPs:
Senior Tranche (AAA) — lowest risk and lowest APR
Mezzanine Tranche (AA) — medium risk and medium APR
Junior Tranche (BB) — highest risk and highest APR
Shown below is the risk comparison for Level Finance, the protocol we're forking this system from.
By modeling the aiPX Protocol's tranche system off of Level Finance's, we've determined the following tranche allocations shown below:
| Tranche | Senior | Mezzanine | Junior | TOTAL |
|---|---|---|---|---|
BTC | 25% | 35% | 40% | 100% |
ETH | 20% | 35% | 45% | 100% |
FLR | 2% | 38% | 60% | 100% |
TBD | 0% | 30% | 70% | 100% |
Displayed above is the percentage of profit or loss given to each asset across the three tranches. In the case of downward market volatility, the Junior Tranche receives the highest risk. To compensate for increased risk compared to the Senior and Mezzanine tranches, the Junior Tranche receives the highest allocation of platform fees, resulting in the highest APR. Conversely, the Senior Tranche carries the lowest risk but earns the smallest share of platform fees.
Trader Alice opens a position of 50 ETH.
Alice's position fees are distributed: 20% to the Senior Tranche, 35% to the Mezzanine Tranche and 45% to the Junior Tranche.
To ensure enough liquidity is available to settle this trade, aiPX reserves a total of 50 ETH from the tranches as follow:
Senior Tranche: 50 x 20% = 10 ETH
Mezzanine Tranche: 50 x 25% = 17.5 ETH
Junior Pool: 50 x 45% = 22.5 ETH
Outcome 1: Alice closes the trade in profit
If Alice closes her trade with a profit of 10 ETH, the 10 ETH will be withdrawn from the tranches and paid out to her balance as follows:
Senior Tranche: 10 x 20% = 2 ETH
Mezzanine Pool: 10 x 35% = 3.5 ETH
Junior Pool: 10 x 45% = 4.5 ETH
ALPs gain fee income and lose 10 ETH, while trader Alice gains 10 ETH and pays trading fees.
Outcome 2: Alice closes the trade with a loss
If Alice closes her trade with a loss of 30 ETH, the 30 ETH will be withdrawn from Alice's collateral and paid to tranches as follows:
Senior Tranche: 30 x 20% = 6 ETH
Mezzanine Tranche: 30 x 35% = 10.5 ETH
Junior Tranche: 30 x 45% = 13.5 ETH
ALPs gain fee income and 30 ETH, while trader Alice loses 30 ETH and pays trading fees.
Trader Bob opens a position of 100 UNI.
Bob's position fees are distributed: 0% to the Senior Tranche, 30% to the Mezzanine Tranche, and 70% to the Junior Tranche.
Normally to ensure there is enough liquidity available to settle Bob's trade, aiPX will reserve a total of 100 UNI from the tranches as follows:
Mezzanine Tranche: 100 x 30% = 30 UNI
Junior Tranche: 100 x 70% = 70 UNI
In this example, the Junior Tranche only has 50 UNI, so aiPX allocates the missing portion from the Mezzanine Tranche, and the reserve ratio is different than the token risk factor:
Mezzanine Tranche: 50 UNI (50%)
Junior Tranche: 50 UNI (50%)
Outcome 1: Trader Bob closes the trade in profit
If Bob closes his trade with a profit of 25 UNI, the 25 UNI will be withdrawn from the tranches and paid into his wallet as follows:
Mezzanine Tranche: -25 x 50% = -12.5 UNI
Junior Tranche: -25 x 50% = -12.5 UNI
ALPs gain fee income and lose 25 UNI, while Bob gains 25 UNI and pays trading fees.
Outcome 2: Trader Bob closes the trade with a loss
If Bob closes his trade with a loss of 60 UNI, the 60 UNI will be withdrawn from Bob's wallet and paid out to tranches as follows:
Mezzanine Pool: 60 x 50% = 30 UNI
Junior Pool: 60 x 50% = 30 UNI
ALPs gain fee income and 60 UNI, while trader Bob loses 60 UNI and pays trading fees.
In the future, risk parameters can be changed according to proposals passed by the aiPX DAO.
This page of the aiPX documentation is paraphrased or directly quoted from Level Finance's documentation, whose revolutionary RMLP system will improve perpetual DEXs moving forward.
