Liquidity Provider Risks on Futureswap

The detailed mechanics and unique protections for the pools’ liquidity providers.

When providing liquidity in a decentralized network, trust in the underlying mechanics is paramount. Futureswap has developed a unique model for protecting the underlying funds and rewarding participants through incentives. Below is a high-level overview of the limited risk liquidity providers take on Futureswap.

Futureswap uses liquidity inside the Futureswap Automated Market Maker (AMM) for trades that are swapped into the Spot AMM (e.g., Uniswap, Fraxswap, etc.). To start, liquidity providers deposit funds into the Futureswap AMM in equal value, similar to adding to other popular AMMs. This liquidity is used for leveraged trades which are swapped back and forth between longs and shorts via the Spot AMM — essentially recycling the liquidity for more trades. Liquidity providers receive trade fees in return for depositing their capital into the protocol.

There are a few items to note about being a Futureswap liquidity provider, but in general, liquidity providers are hedged against trades and therefore delta-neutral.

How is this possible? Let’s go through the flow with an example.

Futureswap’s liquidity providers are automatically engaged into a hedging strategy. When the Futureswap AMM takes the opposite position to a trader, it immediately hedges its position against the Spot AMM with an equivalent position size.

For example, let’s presume a trader takes a 1 ETH long position on Futureswap. The Futureswap AMM then takes a short position of 1 ETH and immediately hedges its position with a long 1 ETH position on the Spot AMM. This means it’s completely delta-neutral and makes the fees with no market exposure.

The only situation where liquidity providers lose is if trades are not liquidated before bankruptcy. This is also the case for most DeFi lending or derivative protocols.

Bankrupt Trades

Just like with any lending platform, the liquidity provider takes a loss when loans that become insolvent are closed.

In this example, presume a trader wants to open a position on the Futureswap ETH-USDC Exchange. The position looks like the following:

Collateral: 10 USDC

Leverage: 10x

Trade Size: 1 ETH

Liquidation Price: $93

Current Price: 1 ETH = 100 USDC

Below is a visual of the different bounds which are set when the trade is open. The trade starts at an open price of $100, and over time the trade moves into the profit range (> $100) or the loss range (< $100).

• The position is only closable by the trader above a price of $93 (yellow and green sections).
• If the price is less than $93, anyone can liquidate the position (orange section).
• If the trade is closed above $90, the liquidity providers receive no loss.
• If the trade is closed below $90, the liquidity providers take loss (red section).

Bankruptcy almost never precedes liquidation. It can happen if there is an oracle outage (such as Chainlink going down), when the underlying blockchain has issues (for example, an Arbitrum outage), or when there are no liquidators available.

The latter situation (when no liquidators are available) is unlikely because:

• Liquidators are incentivized to close trades by earning a fee.
• Anyone can run liquidation bots.
• We actively monitor positions that are liquidatable and receive alerts.

No-Loss Inconveniences

There are two inconveniences for liquidity providers that can occur in extreme cases:

• Limited Withdraw
• Imbalanced Withdraw

In both of these scenarios, liquidity providers’ funds aren’t at risk of losing value. In the worse case, they may not get the same ratio of tokens they put in. Since Futureswap V4 has started in October, the protocol has not seen a scenario where these events have occurred, but we believe they should be noted.

Limited Withdraw

In the case of a Limited Withdraw, the Futureswap AMM is out of balance due to one side being far more popular than the other (too many longs), and the capital from one side has mostly covered over to the other side. Futureswap uses the funding rate to push the Futureswap AMM back into balance for scenarios like this.

For example, let’s consider a Futureswap AMM with Token A and Token B, which starts with 5 of Token A and 50 of Token B. To make the math simpler, let’s assume Token A is $10 and Token B is $1.

Let’s say Bob adds 5 of Token A ($50) and 50 of Token B ($50) for a total value of $100 in his liquidity-providing position. The Futureswap AMM now has a total value of $200 (middle image).

In the third image, the longs vs. shorts ratio is unbalanced. The Futureswap AMM is extremely long Token B.

• Bob wants to remove liquidity.
• The maximum Bob can remove is 3 of Token A and 30 of Token B, a total of $60 worth of liquidity.
• Bob needs to wait until the Futureswap AMM moves back into balance to withdraw his remaining $40.

It’s important to note in this situation no value has been lost for the Futureswap liquidity providers. The only scenario where full withdrawal wouldn’t be possible is when the Futureswap AMM is too unbalanced.

Imbalanced Withdraw

Auto-Deleverage (ADL) is the mechanism by which we allow traders to close their position against other traders when the underlying AMM (e.g., Uniswap) is having issues (e.g., no liquidity). Under normal circumstances, ADL-ing happens against other traders.

In the unlikely event where there are no traders on the other side to ADL against, then the trader closing their position triggers an ADL against the Futureswap AMM. This means that the Futureswap AMM takes a position in stable tokens by selling assets at whatever price the oracle indicates at that time.

ADL-ing against the Futureswap AMM is highly unlikely; most of the time there are traders on both sides — long and short — and ADL occurs between them. This type of situation is called Imbalanced Withdraw, meaning the Futureswap AMM will become slightly off-balance when liquidity providers withdraw at an uneven ratio.

As you can see from the image above, the Futureswap AMM is initially balanced, but after an ADL event against the Futureswap AMM occurs, it becomes slightly uneven. The total value of the liquidity provider position doesn’t change — just the ratio of tokens.

It’s clear why Futureswap is high among the safest markets in which to provide liquidity. There are multiple mechanisms in place — auto-deleveraging and no-loss inconveniences primarily — to protect traders and liquidity providers alike. Nonetheless, for taking on a very limited risk and contributing to the protocol, liquidity providers receive trading fees as a reward. These funds are safe as they’re hedged against traders, making fees with no market exposure. We encourage you to check out the Futureswap public testnet, and to reach out to our team on Discord or Twitter with any questions.

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