Liquidity Providers (LPs) play a central role in providing capital used to underwrite derivatives. You can think of the liquidity pool as a passive market maker who is always available to be a counterpart in a trade. The IPOR protocol reserves capital from liquidity providers (maker) as counterparty collateral for a derivative on the opposite side of the trader (or taker). When the derivative is profitable for the trader, the funds from the liquidity pool are used to cover the payoff to the taker of the swap.
At its inception, the IPOR protocol will be fully collateralized. In other words, the Liquidity Pools will match the collateral from traders at least 1:1. The ratio between the aggregate collateral posted by the traders and the liquidity in the liquidity pool we called utilization.
There are two thresholds when it comes to utilization:
- 80% - up to 80% utilization, the protocol will be issuing derivatives. Beyond 80%, no new derivatives can be issued.
- 100% - At 100% utilization, the protocol will not permit withdrawing of liquidity by LPs
When the utilization is between 80 and 100%, no new derivatives can be opened, and liquidity can be withdrawn. This way, the protocol can ensure that liquidity providers can withdraw all their funds, including those used to underwrite derivatives, without interrupting already opened contracts.
Many parts of the IPOR protocol are meant to be configurable by the future IPOR DAO, such as the risk parameters of the derivative instruments. As utilization represents a form of risk, the protocol will launch conservatively. In the future, DAO participants may choose to change the collateral requirements depending on the performance of the AMM over time.
When an LP supplies funds to the pool, they receive a liquidity token in exchange for their stablecoin. Each currency has its own specific liquidity token such as:
- ipXYZ (Future Stablecoins)
The number of liquidity tokens issued to the user depends on the exchange rate between stable and liquidity token. This exchange rate is calculated in the following way:
As the holdings of the liquidity pool change over time, the exchange rate dynamically adjusts. Holdings may change for several reasons, such as: 1. Deposits by LPs
2. Withdrawals by LPs
The rate is constantly changing based on the market activity to reflect the proportional value of the liquidity tokens held by an LP.
Liquidity pools have a few different ways in which revenue is generated and therefore affects the exchange rate of the ipTokens:
Liquidity tokens can be redeemed for the underlying stable at any point, given that the utilization allows that to happen. To prevent manipulation, a fee of 0.5% is charged on withdrawal. This fee is then redistributed to the remaining holders of ipTokens within the same pool.
As with any liquidity provision, supplying stables to IPOR is associated with certain degrees of risk. Outside of standard 3rd party risks related to potential exploits, there are also economic risks to consider.
Because the funds from liquidity providers are used to underwrite derivatives contracts, the net payout would be covered by the pool's funds if the traders make profitable trades. Spread and utilization thresholds are the measures implemented by the AMM to control the risk of LPs. The AMMs are not tuned for LPs to always be profitable; instead, they are designed to price for risk neutrality as much as possible. Refer to our Spread calculation for more information.