Position size versus locked collateral

One of the defining features of Levana Perps is locked collateral. This is the mechanism by which we ensure that each position's potential gains are well funded at all times. This can lead to some confusion about two similar but distinct topics: position size and max gains. We'll try to clarify that here.

NOTE: This document will intentionally use simplifying assumptions to make the math a bit easier, such as describing a collateral-is-quote market. If you try the same numbers in a collateral-is-base market—which includes any USD-denominated market—the numbers will be slightly different. But that shouldn't impact the intuition discussed here.

What is position size?

Position size represents how much exposure to price movement your position has. It is given by your deposit collateral times leverage. For example, if you deposit $500 in a long position and use 3x leverage, your exposure is equivalent to buying $1500 of the asset on the spot market. If the price goes up by 10%, you will make $150 in profit, not $50.

NOTE: This also explains why all leveraged positions have a liquidation price. In the above example, if the price went down by 50%, the position would have lost $750, which is more than the $500 the trader deposited initially. Therefore, we need a liquidation price that stops a position from losing more money than the deposit collateral. In this case, that would be a 33% price decrease. This also explains why the more heavily leveraged a position, the sooner you'll be liquidated if the price moves against you.

Position size is what determines open interest and net interest in the platform:

• Long open interest is the sum of the position sizes of all longs.
• Short open interest is the sum of the position sizes of all shorts.
• Total open interest is the sum of long and short open interest.
• Net open interest is the difference between long and short open interest.

What is locked collateral?

When you open a position, you specify a take profit price. Internally, the system converts this into a max gains, representing the maximum amount of profit you can ever take from this position. This occurs by borrowing liquidity from liquidity providers and locking it against your position.

Let's use the example above again. You have a long with a $1500 position size. The current price is $10. You set a take profit price of $12, or a 20% price increase. That means your max gains are $1500 * 20% == $300. The protocol needs to borrow those $300 from the liquidity pool and lock it into your position. This is the locked collateral, or equivalently the counter side collateral.

By constrast, if you reduce your take profit price from $12 to $11, the protocol only needs to lock collateral for $1500 * 10% == $150. Notice that the position size remains the same in both cases, but the locked collateral is significantly different.

As you can see in this example, the closer the take profit price is to the entry price, the smaller the locked liquidity. This is one of the reasons we recommend traders think carefully about the take profit prices they want. Not only is this a risk mitigation mechanism, but it is also a cost savings. Reducing your locked liquidity will reduce both your trading fees and your borrow fees.

Price risk to liquidity providers

Let's continue with the above example. A trader opens a long with the parameters:

The system will derive the following from these parameters:

Any gain the trader takes on the position will be withdrawn from the locked collateral, and vice-versa. Meaning, if the price moves up to $11:

• The trader has experienced a 10% increase via price exposure
• The trader will have profits of $1500 * 10% == $150
• The liquidity pool will lose those $150 to the trader
  • Caveat: as we discuss below, we strive to keep the protocol balanced, which will protect liquidity providers from these losses by ensuring for every loss on a long position, they will experience an equivalent gain on a short position, and vice versa.

Similarly, if the price decreases by 10% instead, the trader will lose $150 to the pool. This is equivalent to saying that, every time a trader opens a long, it's as if the liquidity providers have opened a short of the same position size. This leads to one more concept: counter-side leverage. In our example, the liquidity pool opened a $1500 short position using $300 of collateral. This means that the pool's counter-side leverage on this position is 5x, versus the trader's 3x leverage. From the liquidity pool's perspective:

Why net open interest matters

The reason why net open interest is so important to the protocol is because it represents exposure to price risk for liquidity providers. If the protocol has too much long interest, for example, liquidity providers are being forced to open up more short positions than long positions. If the actual price goes up, liquidity providers will lose funds to traders through impairment. It's true that if the price moves down instead, liquidity providers will instead make money through impairment. But we strive to insulate providers from risk. Therefore, our goal is to keep longs and shorts balanced, also known as:

• 0 net notional
• Delta neutral

The mechanisms we use for this are incentives via funding rate payments and delta neutrality fees, which provide a profit motive for the implementation of cash-and-carry arbitrage, also known as basis trading.

Collateral lock-ups, risks and rewards

The inherent risk liquidity providers take on in this system is unbalanced price exposure. While—as just discussed—the protocol strives to minimize that risk, it cannot guarantee risk will be absent. And furthermore, in extreme market conditions (called a market meltdown or meltup), this risk is expected to be very high. In such a scenario, any liquidity in the pool is at risk of impairment, up to loss of 100% of their funds.

Liquidity providers can choose their level of risk, and receive commensurate rewards as a result. Therefore, there are two mechanisms for providing liquitity: LP tokens with no lock-up time, and xLP tokens with a 45 day lock-up window. LP tokens can be immediately withdrawn, provided that enough liquidity is in the system. xLP holders take on a higher degree of risk, and therefore receive higher rewards in terms of receiving a higher proportion of trade and borrow fees.

But to be clear, both groups are at risk of significant impairment. The protocol uses a dynamic borrow fee rate detection mechanism within the protocol to allow supply-and-demand forces to discover a fair market rate for this risk, a mechanism discussed in much more detail in our whitepaper. But the summary is: for assuming the risk of extreme market movements, LP and xLP holders are rewarded with high APRs on their deposits.

More details

This document attempts to focus on just the question of position size versus locked collateral. There is more information available in the rest of the doc site which may be relevant:

• High level technical overview
• The explainer slides give many more examples. The liquidity pools, trading overview, and collateral is base decks will be especially relevant.