Under normal conditions, when an LP deposits liquidity into Notional, the system mints an offsetting pair of fCash tokens and places the negative side into the nToken's portfolio and the positive side into the liquidity pool along with the LP’s capital (Prime Cash). On a net basis, the LP’s holdings have not changed because the additional negative fCash in the nToken account portfolio offsets the additional positive fCash (in the liquidity pool) that he has a claim to. But this process allows the LP to place tokens summing to a value that is greater than his capital into the liquidity pool.
Consider an example liquidity pool containing 100 Prime USDC and 100 fUSDC. If a liquidity provider deposits 100 Prime USDC into this pool, he will mint an offsetting (100 fUSDC, -100 fUSDC) pair so that the LP can place 100 fUSDC into the pool along with his 100 Prime USDC. This means that the pool now has 200 Prime USDC and 200 fUSDC. The pool's assets have increased by about 200 USDC even though the LP only deposited 100 Prime USDC of capital. This is what we call LP leverage. In this example, the liquidity provider has provided liquidity that is double the total value of his initial deposit. We would say that the LP is 2X levered in this scenario.
Benefits of LP Leverage
Leveraging liquidity allows LP capital to be used much more efficiently in the protocol, resulting in lower slippage for fixed-rate lenders and borrowers. Every time a user borrows or lends, the market interest rate changes - slippage describes the amount that the interest rate changes for a given loan size. Lower slippage means better UX.
Risks of LP leverage
With leverage comes risk. As fixed rate lenders and borrowers trade, the nToken account takes the net opposite position of traders. Assuming users are net fixed rate lenders the nToken will hold a net borrowing position. If the net fixed borrow rate of this fCash position is lower than the Prime variable rate, then the nToken account will lose money over time as it is borrowing fixed at a higher rate than it is earning on its variable position. It is thus important to set a limit on the amount of LP leverage that one can take when minting nTokens to make sure that the nToken account never experiences material losses and, more importantly, never becomes undercollateralized.
The leverage thresholds dictate the maximum utilization rate at which the nToken account can provide liquidity to each liquidity pool. If during the course of minting nTokens, a liquidity pool’s utilization is greater than its leverage threshold, the nToken will lend to that liquidity pool instead of providing liquidity thereby decreasing the market's utilization.
Purpose of the leverage threshold
The purpose of the leverage threshold is to ensure that an nToken account does not become undercollateralized by providing liquidity to individual liquidity pools at leverage ratios that are too high. Leverage thresholds also aim to lower interest rates by lending when a pool's proportion becomes abnormally high.
nToken accounts value must always be positive. Therefore we must ensure that the highest possible interest rate at which the nToken account can provide liquidity (the leverage threshold) would allow the nToken account’s value to remain positive even if interest rates decreased from the leverage threshold to 0% in infinitesimal trading increments without any passage of time.
Gorvenance can rely on simulations to validate the robustness of the selected parameters.
Leverage thresholds selection optimizes for the following properties:
the nToken accounts should never become undercollateralized;
leverage thresholds are set at or close to the fCash kink2 utilization rates for simplicity.