iAsset LP Liquidity Spiral

I have been thinking a lot about iAsset LP Liquidity and the importance of deep liquid markets for iAssets. I think there may be a low probability, but potential iAsset Liquidity Spiral scenario. The best way to describe it is an example…

Example:
Let’s say BTC spikes massively versus ADA. Let’s also say that most people who mint iBTC use ADA as collateral. There would be a potential for mass amounts of Liquidations of any iBTC CDPs (collateralized debt position). Now, this is not a problem because I assume there will be a lot of iBTC Liquidation Pools (LiqP) that will make some money as the iBTC CDPs fall below their required CR (collateral ratio).

Now, those LiqP providers may have their own iBTC CDPs as well. Let’s assume many of them are thoughtful with their CRs and either overcollateralized by a good amount of topped up their collateral during the BTC runup, so they are not liquidated as well. These LiqP providers now have CDPs without the necessary iBTC to close their position. They were given ADA as part of the liquidation process. There may now be a massive amount of flow needed to sell ADA and buy iBTC in order to have the iBTC to close the CDP.

In addition, anyone who provided liquidity to the iBTC/ADA Liquidity Pool (LP), is going to have a decent amount of Impermanent Loss (IL). As iBTC increases relative to ADA, LPs will have less iBTC and more ADA then they initially deposited. And if those people also created iBTC CDPs, they may have less iBTC then they need to close their CDP. So this could potentially put further upside pressure on iBTC vs ADA as LPers need to sell ADA and buy iBTC to make sure they have enough iBTC to cover their CDP. Also, they may pull their LP as IL becomes larger and larger.

So I am wondering what the communities thoughts are around this potential iAsset Liquidity Spiral.

To Summarize:
-iAsset Spikes causing mass amounts of liquidations
-Liquidation Providers receive collateral and sell that collateral for the iAsset, putting further upward pressure on the iAsset price
-Liquidity Providers are hit with Impermanent Loss, and need to also buy the iAsset to make sure they have enough iAsset to cover CDPs
-Liquidity Providers may close LP positions as IL becomes unmanageable
-This causes a massive upward feedback loop on the price of iBTC, creating more liquidations and furthering the process, etc.

Overall, if this potential scenario is possible, even if it is very unlikely, it leads me to believe that deep iAsset liquidity markets are needed.

Potential Solution:
Pseudo Protocol Owned Liquidity (pPOL) of iAsset/ADA (or iAsset/common collateral) pools. Indigo could own pPOL outright by using treasury funds to swap and LP into some of the major iAsset LP pairs. Indigo could propose a bonding process of selling discounted INDY for people willing to sell their LP tokens to Indigo. Indigo could look to incentivize liquidity in LPs with low levels of TVL (I believe this is already in the plan, thanks for being so thoughtful Indigo Team!), and LPs that are experiencing high levels of IL with INDY emissions.

I am not sure any of these solutions truly work. But I did not want to raise a potential concern without at least proposing a solution.

I look forward to hearing the team and community’s thoughts on this topic!

–Marco

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Would something like the SigmaUSD (on Ergo) or Djed methodology be a means to address these concerns?

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Interesting thought experiment. A few things come to mind for me. 1) does this come down to over collateralizing and perhaps LP providers have an option to pad their over collateralized positions (This would come with some drawbacks and probably not the most effective use of capital. 2) LP providers being able to set a stop loss to limit the amount of IL they experience. 3) Being your own bank means you have to DYOR and acknowledge that you can get hammed in some positions necessitating balancing your portfolio and LP positions.

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Interesting exercise, however, it is necessary to remember what @defiroose mentioned, “Indigo isn’t a DEX and there isn’t a risk of impermanent loss due to Indigo supporting only single-sided staking”.

The quote is in this topic:

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But there is IL if you choose to take you iAsset to a Dex and provide liquidity (so pair it with another token). Lets say you mint iBTC and instead of putting it in the liquidation pool (i beleive this is what you are referencing… liquidation pools are solely within Indigo and provide single asset/sides depositing so no IL)… you choose to pair your iBTC with ADA and deposit both into a DEX (SS or Minswap, etc.). This is what I am referencing when I say LP and liqudity spiral. Someone is goinf to have to do traditional LPing so that we can swap between iAssets and tokens and ADA! Sorry for the confusion! Please correct me if i am wrong, but i dont see how traditional LPing with iAssets and any other token (including other iAssets) wont have IL.

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All good points! I like to hope that everyone DYOR and understands not only the risks of CDPs, but also LPing in general. I am not sure if i fully understand your first point. BUT… if its something like… if you deposit your LP token in Indigo (to farm INDY maybe)… maybe Indigo could count some part of thay as collateral. So say you mint iBTC and LP into an iBTC/ADA pool… if u deposit that iBTC/ADA LP token into Indigo… could some portion of that be counted as collateral?

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I was thinking something along those lines.

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Hmmm I am not sure TBH. If i remember Djed is an algorithmic based stablecoin. So I actually think its under collateralized not over collateralized. But i definitely may be wrong there!

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Yeah that could be a really interesting idea! Love it!

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iAssets are pegged to the price of their underlying asset. So iBTC is pegged to the price of BTC. iBTC may not always trade the same price of BTC. When price deviates it creates opportunities to profit.

There’ll likely be multiple liquidity pools for each iAsset due to market demand. So while iBTC/ADA may become mispriced, iBTC/dUSD may be correctly priced. In this scenario an arbitrageur can fund iBTC by opening a new CDP, sell their iBTC for ADA, convert ADA to dUSD, use dUSD to buy iBTC, then use the iBTC to close their BTC for a nice profit.

Let’s take the example of Arb. Arb is actively on the lookout to make profit with low risk. Arb sees that ADA is selling for $1 and BTC is selling for $40k. He discovers that iBTC/ADA is priced at 41k. In order to take advantage of this opportunity, Arb takes the following steps:

  • Deposits 68k ADA into Indigo
  • Funds 1 iBTC
  • Sells 1 iBTC for 41k ADA
  • Sells 40k ADA for 40k dUSD
  • Buys 1 iBTC for 40k dUSD
  • Sends 1 iBTC into Indigo to unlock his original ADA

Arb now has 69k ADA (minus fees).

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Djed uses a staticoin based algorithm to maintain a synthetic price peg. Whereas Indigo uses a CDP based algorithm to maintain a synthetic price peg.

Static/Djed is based on the principle of having two tokens to maintain a peg. One is the synthetic token pegged to a price of another asset. The other is a reserve token. These two tokens work together in a mint-and-burn model to maintain the price peg.

Djed is still overcollateralized just like Indigo. Djed’s algorithm has several advantages over Indigo’s algorithm under certain conditions such as blockchain congestion and high volatility. This is one reason Indigo has partnered with COTI (creator of Djed). If Djed’s algorithm proves to be successful then we can consider utilizing it for some of Indigo’s iAssets.

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Thanks for clarifying this points raised.

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This is really helpful thank you! The multiple liquidity pools would help keep price pegged, I totally see that, but do you also think it may fracture liquidity? What I mean is, in your example, you would need 2 pools for iBTC (crossed with ADA and dUSD) to have sufficient liquidity so there is not too much slippage. If slippage is too high, it may not be profitable for the Arb’er. But if there is enough liquidity across the pools, I don’t see this as an issue. I guess this is my only small fear right now, sufficiently deep liquidity across the iAssets.

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If slippage is high it creates another arbitrage opportunity to make profit. Fractured liquidity isn’t concerning because the market is self correcting. If an opportunity exists to make money then a market participant will exploit that opportunity to maximize profit until that opportunity no longer exists.

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Thanks for the constant responses! What is the arbitrage opportunity from slippage? I am struggling to wrap my head around how you can arb a large trade on a CPMM. If a want to trade an amount equal to 5% of the total value of the LP… my slippage could be 10% of the price (if price is 5 ADA/iUSDC, supplying 5% worth of iUSDC to the LP to get back ADA, the price I receive is 5.5 ADA/iUSDC). What is the arb opportunity here?

Slippage will cause the price to move. If the price moves then someone can take the other side of the position to correct the price.

That bulleted flow makes sense. Opportunity for sure. It did take some digesting before I was able to wrap my head around it, but I think (in the interests of driving mass adoption) a simplified video explanation of this arbitrage opportunity/option may pique the interest of relatively new investors who have funds but are not as yet sufficiently versed to really understand various opportunities Indy and synthetic assets provide.

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I guess I am not articulating my point well. My point was more that if pools only have a small amount of capital in them, someone who wants to arb the price of the pool may not actually be able to without causing massive price movements, potentially above the ‘true’ market price of the asset. The ‘true’ market price would have to deviate pretty far from the pool price of the asset in order for someone to arb that price. But I do get your point. I just hope we see plenty of liquidity in all iAsset pools! I think good liquidity will help this ecosystem grow

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You will be able to do it. It’ll require some effort and possibly multiple transactions. So long as the profit incentive is there somebody will do it.

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Folks taking an arbitrage opportunity is the markets way of keeping the various markets in line with one another. You just need to take the arbitrage opportunity before someone else does :wink: