Liquidity tokens represent a claim on the assets that sit in a liquidity pool at a given maturity. Liquidity tokens can be decomposed into a claim on cTokens and fCash. The value of liquidity tokens is a function of:
- the trading activity in the liquidity pool (liquidity fees and impermanent loss);
- the Cash (cToken) yield;
- the fCash yield.
If an account holds liquidity tokens and its free collateral value turns negative because liquidity tokens decrease in value, a liquidator could force the account to convert its liquidity tokens into their underlying Cash and fCash claims to lower the risk of the account's portfolio.
The size of the move in the value of liquidity tokens that the protocol can handle before an account becomes undercollateralized and the incentive used to attract liquidators to convert liquidity tokens into its underlying claims are dictated by the Liquidity Token Haircuts and the Token Repo Incentive respectively.
Liquidity Token Haircuts are applied to the underlying claims of liquidity tokens during the free collateral calculation. Liquidity token haircuts enable the protocol to recognize only a percentage of a liquidity token’s cToken and fCash claims to determine a user’s free collateral. The liquidity token haircut is unique to each active cash group’s tenor and aims to reflect that longer-dated liquidity tokens are riskier than shorter-dated liquidity tokens.
Let’s note that the chosen liquidity token haircut also defines the greatest proportion at which a liquidity provider can provide liquidity (trying to provide at a higher proportion would fail as it would result in a negative free collateral position).
Liquidity Token Haircut impact on collateral calculations
The purpose of the Liquidity Token Haircuts is to mitigate the risk the protocol could face from a decrease in the collateral value of Liquidity Tokens.
For example, if market participants increasingly lend in a given pool the pool's interest rate would decrease. During that process, LPs would become effective borrowers with an increasing negative net fCash position. As interest rates decline, the present value of fCash also increases. Thus the net present value (NPV) of a liquidity provider’s position decreases. We hereafter present the hypothetical impact of a decrease in interest rates on a liquidity provider’s NPV if he initially provides liquidity at the 0.95 proportion in the 1 year maturity pool.
Liquidity Tokens NPV following a decrease in interest rates:
The above example showcases that a ~5% decrease in interest rates would decrease a liquidity provider’s NPV by ~50%.
Our liquidity token haircuts selection process relies on simulations to validate the robustness of the selected parameters. The selected liquidity token haircuts aim to maximize the likelihood of an orderly liquidation process and protect the protocol against a rapid decline in the liquidity token’s value.
Let’s recall that liquidity token haircuts define the greatest proportion at which liquidity providers can provide liquidity. Thus, we can simulate a liquidity provider’s loss following an instant interest rate decrease of 5% for increasing starting providing proportions values until the LP’s loss is higher than 1 minus the starting providing proportion.
This proportion and its corresponding interest rate is the maximum providing proportion where the protocol can withstand a 5% instant decrease in interest rates without incurring any loss. We can then validate if a particular liquidity token haircut is set at a lower level than 100% minus the LP’s simulated loss. If that is the case, the protocol would be protected against a potential interest rate decline of 5%.
We selected the following liquidity token haircuts for the cash group initially supported:
We simulated the expected LP loss following an instant 7.5% decrease in interest rates based on the selected AMM curves. The simulation results validate that the selected liquidity token haircuts are sufficient to protect the protocol against a loss in the value of liquidity tokens following an instant interest rate decline of 7.5%. In other words, the selected haircuts are lower than the maximum proportion resistant to a decline of 7.5% in interest rates.
When liquidity tokens are converted to cash and fCash during liquidation, the liquidated account sees a certain amount of local currency collateral benefit. The Token Repo Incentive is the percentage amount of that collateral benefit that is paid to the liquidator.
When a liquidator forces an account to convert their liquidity tokens into their underlying Cash and fCash it lowers the risk of the account's portfolio and increases the collateral surplus (or decreases the collateral requirement) in the liquidity token currency. Liquidating liquidity tokens does not require the liquidator to purchase or deliver any asset.
The token repo incentive incentivizes liquidators to trigger these conversions.
Based on our analysis of the free collateral benefit received by liquidators after gas, we selected the following liquidity token repo incentive: