Risk Management for Liquidity Providers
Risk management is one of the core strengths of the LEVEL ecosystem. Therefore it was only fitting we build an innovative design for liquidity providers centred around this.
Taking inspiration from traditional markets, we adapted a creditor structure to provide multiple levels of risk for digital asset pools. Developed entirely from scratch, the Risk Management & LP Seniority on the Credit Table (RMLP) system separates liquidity pools into Tranches with varying risk profiles for liquidity providers.
These tranches represent the underlying exposure of LEVEL Liquidity Providers (LLPs) to the assets within each pool as well as to the PnL of traders on the platform.
The RMLP system aims to:
- Separate risk exposure to the underlying assets in Tranches, by housing higher-risk assets in specific pools
- Tackle functional issues endemic to zero-price impact perpetuals, such as long-tail risk, by isolating risk exposure on higher risk-tolerant liquidity providers
A Tranche has become a popularized term in traditional finance, most frequently in the context of MBS. Tranching is a mechanism where a pooled collection of securities or assets are split up according to risk, to be marketable to investors with different risk appetites. Tranches usually range from the lowest risk (AAA), down the risk scale (BB and lower) where a higher potential upside is available.
At LEVEL, each tranche represents a specific pool of assets from those available on the platform, such as BTC, ETH, BNB, and stablecoins. By offering different risk profiles, each tranche allows LLPs to choose how much risk they are willing to take.
LEVEL offers 3 tranches for LLPs:
- Senior Tranche (AAA) — lowest risk and lowest APR
- Mezzanine Tranche (AA) — medium risk and medium APR
- Junior Tranche (BB) — highest risk and highest APR
All Tranches earn fees from traders on the platform, shown as Fee APR on each Tranche page. These fees are automatically compounded into each LLP token leading to an increase in the price of each LLP. As a result, the amount of total LLP tokens for a Tranche will not increase but the value of them will.
For example, if the Senior Tranche started with $1M of value, with an LLP price of $1 and a flat Fee APR of 100%, after different time periods the Tranche value and price would be as follows (assuming no change to underlying asset prices).
Each tranche is exposed directionally to its underlying assets as well as acting as the counterparty to traders on the platform. Tranches share directional risk to the underlying liquidity assets on the platform equally. Conversely, counterparty risk is segregated according to the following Risk Factors.
The figure above show the percentage of profit or loss (PnL) of each trade that is attributed to each tranche per asset traded. In the case of unexpected shortfalls resulting from adverse market conditions, or from other incidents, the Junior Tranche bears the highest risk. To mitigate increased risk compared to the Senior and Mezzanine tranches, the Junior Tranche receives the highest allocation of platform revenue and thus enjoys the highest APR. In contrast, the Senior Tranche bears the lowest risk but also earns the smallest share of platform profits.
These presented ‘Risk Factors’ reflect the amount of PnL exposure of a tranche and the proportion of distributed fees collected.
Scenario 1: All tranches have sufficient assets
- 1.Trader Bob opens a position of 100 ETH.
- 2.Bob’s position fees are distributed
- 20% to Senior Pool
- 35% to Mezzanine Pool
- 45% to Junior Pool.
- 3.To make sure there is liquidity available to settle Bob’s trade, LEVEL reserves a total of 100 ETH in the pools as follows:
- Senior Pool: 100 x 20% = 20 ETH
- Mezzanine Pool: 100 x 35% = 35 ETH
- Junior Pool: 100 x 45% = 45 ETH
- 4.Bob closes his position in 20% profit, booking 20 ETH, as shown in the following example
In some market conditions, there may be a shortfall in one of the tranches to cover the profit of a trade. In such an instance, the missing portion will be allocated from across other tranches that hold sufficient assets leading to a Reserve ratio that may differ from the token Risk factor. The Risk Factor determines the Reserve Ratio desired for each tranche. If there is enough liquidity, then the Reserve Ratio = Risk Factor. Based on this Reserve Ratio, the Return Fee and Return PnL of a tranche are calculated as demonstrated above.
Scenario 2: One of the tranches has insufficient assets
- 1.Trader Jack opens a position of 1000 BNB
- 2.Jack’s position fees are distributed
- 1.2% to Senior Tranche
- 2.38% to Mezzanine Tranche
- 3.60% to Junior Tranche
- 3.In normal conditions, to make sure there is liquidity available to settle Jake’s trade, LEVEL would reserve a total of 1000 BNB in the pools as follows:
- 1.Senior Tranche: 1000 x 2% = 20 BNB
- 2.Mezzanine Tranche: 1000 x 38% = 380 BNB
- 3.Junior Tranche: 1000 x 60% = 600 BNB
- 4.However at the time, the Junior Tranche only had 500 BNB, therefore LEVEL allocates the missing portion from the Mezzanine Tranche, creating a new reserve ratio that is different from the token risk factor:
- 1.Senior Pool: 20 BNB (2%)
- 2.Mezzanine Pool: 480 BNB (48%)
- 3.Junior Pool: 500 BNB (50%)
- 5.Jack closes his position in 10% profit, booking 100 BNB, as shown in the following example
As evident from the examples above, the fee income distributed to each tranche is also split relative to the risk factors. This is to align higher-risk tranches with a higher yield, further incentivising LLPs willing to take on more risk.
Proposals passed by the Level DAO can change the risk parameters of RMLPs.