A Risk-Indifferent Approach to Passive Liquidity Provisioning
Core Challenges for Liquidity Providers
Liquidity providers (LPs) must deal with a minefield of risks when evaluating opportunities. The main inefficiencies LPs deal with within the perpetual futures space include:
LPs being unwilling and unprotected counterparties to smart traders
LPs not being compensated properly for taking on that risk
Protocol/AMM insolvency.
Problem #I: Settling Trader PnL
AMM-based dexes require LPs to put up idle capital in order to facilitate trading. LPs receive trader losses and fees for doing so but are also required to fulfill trader profits. A profitable trading environment can result in negative returns for LPs, wiping out gains from steady double-digit positive returns from months prior. A lack of proper risk management has long been inherent to passive LP strategies.
Problem #2: Lack of Proper Compensation
In most models, LPs are compensated for taking on the above risk with fees. These are often a few basis points per trade that allow these pools to offer what often looks like low double-digit yield. In a neutral/risk-off market environment, these returns can often remain steady and sustainable. But in a volatile/risk-on market environment, returns can be wiped out in a single day. Even in calmer market conditions, an intelligent trader(s) can drain LP funds with a profitable trade or strategy - a risk rarely reflected in the 15% APY users see on the frontend.
Problem #3: Insolvency
An issue specific to undercollateralized systems, insolvency can occur when an AMM takes on more liabilities than assets without a proper hedge. Should a dex become insolvent, LPs may be unable to withdraw their initial capital while traders may not be able to close active positions. A number of virtual AMMs and other protocols have seen their downfall as an unintended outcome of trying to create a more capital-efficient system.
Risk-Indifferent LPing with Vest Exchange
Vest is an AMM-based perpetual futures dex, built on zkSync. The above problems are addressed on Vest by:
Creating a barrier between traders and LPs via AMM capital
Paying risk-adjusted compensation to LPs
Dynamically adjusting the cost to trade based on its effect on insolvency risk.
Vest is an AMM-based dex with a proprietary risk management system known as zkRisk, designed to protect LP capital while safely increasing capital efficiency for traders. The AMM is the first point of contact for traders, providing liquidity for trades and taking on all trader PnL until it no longer has any available liquidity. At this point, LP capital is used to fill trades. Regardless of the counterparty, a portion of the fees from a trade always go to LPs in order to maintain a stable balance. These fees consist of flat execution fees and premia.
Premia
Traders will have to pay an additional premium when executing specific trades. The Vest AMM assigns a monetary risk measure, Entropic Value at Risk (EVaR), to any given trade. This value measures the capital needed to minimize the probability of a position (in this case, the AMM) going underwater. EVaR is applied to the difference between liabilities (trader profits) and assets (current liquidity + collected premiums) to determine a risk value at any time. Premia is calculated by taking the difference between the risk after accepting the trade and the risk before accepting the trade. If the trade increases risk, the trader is charged a premium proportional to the additional risk it introduces.
Premia is distributed to the AMM and LPs, along with execution fees going directly to the LPs. The fee distribution is roughly detailed as follows:
Premia: paid to both AMM and LPs
Execution fees: paid to LPs and the Vest team.
Trader PnL is settled by AMM capital, while fees are split between the two sources. Premia is used to maintain a healthy risk level for LPs and the AMM. Execution fees are used solely to ensure positive PnL for LPs. Premia is split between the two sources for two different purposes - AMM capital receives premia in order to maintain solvency while LPs receive premia in order to maintain risk-indifference. The EV of LP gains is intended to be 0 in any market conditions - LPs keep what they initially deposited, while execution fees are routed directly to them in order to generate steady yield based on demand rather than the profitability of traders.
While Premia is used to mitigate inventory risk for Vest, funding rates are used to mitigate price risk; the risk associated with the changes of price in the held assets. Vest distributes funding rates via Euler Allocation, a traditional risk distribution method that evenly distributes funding across markets. Euler Allocation determines a risk measure for each asset, which is then multiplied by the percentage of open interest owned by a trader in that market to calculate the funding paid. This allows funding to be evenly distributed throughout the system, correcting long/short imbalances while protecting the system from price risk.
Capital Efficiency Without Insolvency
Most AMM-based perpetual futures dexes must either set an open interest (OI) cap or risk an insolvency scenario. This prevents these dexes from meeting trader demand and reduces capital efficiency, as the system can usually only take on (at most) as much OI as there is TVL. Vest uses a risk engine to dynamically affect the cost of trading based on the quantifiable risk metrics, removing the need for OI caps. This allows the exchange to safely move past traditional OI caps and even scale OI past TVL without being at risk of insolvency. Doing so also allows LPs and the AMM to earn more, since Vest can handle greater OI it will be able to generate more fees.
Many perp dexes fall victim to the chicken-and-egg liquidity problem, where low liquidity results in a less ideal trading environment, which leads to lower fees for LPs, exacerbating the low liquidity issue that started the cycle. By prioritizing safety while increasing capital efficiency, Vest can become one of the most liquid on-chain perp trading venues. This will prevent the liquidity death cycle from taking place, maintain and steadily grow LP capital, and offer dynamic pricing and deep liquidity for traders.
Providing Liquidity to Vest
The process of LPing on Vest will be familiar to most LPs. Users can deposit any amount of USDC and immediately begin earning fees on their deposit. The initial USDC deposit is intended to remain stable while earning interest primarily via fees rather than trader PnL. Once an active LP chooses to withdraw, they must first signal the intention to do so, triggering a 24-hour waiting period. After this, the LP can withdraw with no issue. Should they choose to withdraw immediately, Vest charges an additional withdrawal fee - this fee is calculated similarly to trader premia in that it’s used to balance LP risk. This is to maintain Vest’s approach to data-driven security; 24 hours gives the system enough time to price the loss of capital and adjust all parameters accordingly.
More Information Coming Soon
Vest Exchange is being built with a math-centric approach to bring numerous innovations to the on-chain perpetual futures space. Providing a risk-indifferent approach to LPing is just one way Vest aims to offer one of the strongest on-chain trading venues in DeFi. Over the coming weeks, you can expect to see more info on Vest’s key features for all kinds of users. In the meantime, we’d encourage anyone looking for further information to read and participate in the ongoing discussion on our research forum. To keep up with all current news and information, follow us on X and join our Discord.