Spread is essentially a tool to control the risk exposure of the liquidity pool. The IPOR Protocol's spread configuration for the Interest Rate Swap is set in such a way to keep the spread as narrow as possible to incentivize market activity while minimizing the risk to which the liquidity pool is exposed.
Having a low spread creates an ideal situation for traders as they can get exposure to the rates with a minimum premium. However, this could also limit the availability of capital to underwrite such risk as the pool could be fully utilized without creating any return incentive for the pool, disincentivizing LPs to lock capital. Therefore such situations would limit the utility of interest rate swaps.
Having a high spread would be great for liquidity providers since they would always be very profitable, and their exposure to the risk would be minimal. Unfortunately, such swaps would provide little utility to the traders.
The sweet spot lies somewhere in between:
- Having a low enough spread so that derivatives instruments are useful for hedging and speculating for traders
- Having a high enough spread so that LPs are not exposed to an unreasonable level of risk
To achieve such spread levels, we run a large number of simulations using historical rates data and a series of market tests popular in quantitative finance. The future IPOR DAO will be responsible for further improving the spread models to maximize utility and efficiently manage risk.
Several factors contribute to the risk that the liquidity pool has to underwrite.
- volatility - current levels over a given time horizon
- volatility historical - reversion to the mean level
Each of these components is used to calculate the fair and effective spread.