Liquidity Extension — Malt’s PCV

Extend as far as you can. It will help you stay stable

At Malt, we quickly realized that protocol-owned liquidity would significantly improve the prospects of an algorithmic stablecoin. Such liquidity from the protocol would allow implementation of designs that better incentivize stability. As it turns out, other projects had a similar realization (e.g., FEI’s “protocol-controlled value” and OHM has similar ideas as well). At Malt, our concept is a little different, and we use the term “liquidity extension,” as this better represents the Malt implementation of protocol-owned liquidity.

The Source of Liquidity Extension

Malt’s liquidity extension (LE) is grown using a cut of profits from supply expansions. Specifically, 20% of all expansion profits are contributed to LE, which is a reserve of capital that is not a part of the AMM liquidity but is added to the AMM pool as needed (thus, the term “liquidity extension”).

The protocol defines a minimum level of LE, which is expressed as a ratio of the total amount of Malt in the liquidity pool (“reserve ratio”). The minimum reserve ratio set by the protocol is 20%, meaning that at any given time, the ratio of LE capital to AMM Malt should be at least 20%.

Due to the fair launch described in the previous article the amount of Malt in the pool is initially low so the expansion rewards created from the buying at launch will quickly fill the 20% minimum LE required.

Use of Liquidity Extension

The primary use of LE is to aid in supply contraction through participation in the arbitrage auctions. Specifically, during auctions, every single arb token purchased by a participant has a corresponding LE contribution. The total amount contributed between the arb purchases and the LE are used to purchase Malt directly from the AMM liquidity pool, which is then burned, resulting in supply contraction.

The exact amount of LE contributed to the auction is dynamic and responds to factors such as historical auction participation as well as how frequently the price has been above and below peg recently. The aim of the LE contribution is to provide a backstop to the auction while improving the token economics of Malt by burning more Malt than is required to pay the arb token premium — resulting in a real realised supply contraction.

The hard limit on LE usage is it must try to at least maintain the reserve ratio before and after the auction. In many cases it will try to improve the reserve ratio by choosing to not use the entire LE budget to burn but instead hold some back to improve the reserve ratio.

This implies a decision between burning Malt and improving the LE reserve ratio. The general heuristic is that if participation in the auction is high then the protocol will lean towards burning more Malt and maintaining the reserve ratio. If participation is low then it will lean towards improving the reserve ratio and not burning as much Malt.

This latter point means that during times when auction participation is persistently low and Malt market price is below $1 for long periods, the protocol will prioritise improving the reserve ratio across auctions, allowing the protocol to push itself back to $1 by directly purchasing and burning Malt. If the reserve ratio ever reaches 100% then there is no need for auctions as the LE will be fully backing the Malt in the liquidity pool and it can simply just buy back enough Malt to return to peg.

The exact technical details of how the LE is used during the course of an auction will be detailed in the whitepaper.

Lastly, it is also worth noting that at the start of each auction, LE contributes a pre-specified amount of capital to the auction before any bids, pushing the price up immediately improving the potential for a satisfactory premium as the auction progresses.

Implications of LE

There are a number of advantages that LE confers to the protocol stability:

1. Perhaps most importantly, LE allows for a true elastic supply of Malt, such that supply can contract even in the absence of auction engagement from market participants. This is vital, because an algo stablecoin implies that supply can and will contract.
2. The contribution from the LE allows more Malt to be burned than needs to be minted later to pay the auction premium. If Malt price is $0.90, auction price ends at $0.80, the LE can contribute an extra $0.20 per auction bid (assuming a worst case price of $1 per Malt), which results in an additional $0.10 of burn per bid even after covering the $0.10 premium. Whether the protocol makes this extra contribution is determined by recent levels of auction participation.
3. The minimum price of an auction is set to ensure the rate of reserve depletion is lower than the rate of burning Malt from the liquidity pool. For example if the minimum price of the auction is $0.50 and the current Malt market price is $0.8 then the maximum amount of LE contribution per Malt burned is $0.30. The difference between the auction minimum price and the market price of Malt is the maximum excess the LE will have to cover. By choosing the correct minimum price the protocol can cap the amount of LE used such that the reserves deplete slower than malt is burned. I.E. using 5% of LE to burn 8% of the Malt in a pool. Because the pool is depleting quicker than LE, the reserve ratio improves.
4. When auction participation is low, the protocol will contribute less excess LE to burn additional Malt, instead holding onto LE to increase the reserve ratio. This will result in progressively increasing reserve ratio with low auction participation, until Malt the ratio of reserve capital to LP malt is high enough that Malt can “self-heal,” pushing price back to $1 without auction participation. Auctions automatically cease once the ratio hits this level.
5. Participation for most auctions will fall between extremes of high and low participation, meaning the LE contribution will dynamically balance extra Malt burn with increasing reserves based on where on the spectrum the auction participation falls.

Conclusion

Malt offers a completely unique combination of mechanics to facilitate stability. The liquidity extension is one of the most powerful and sophisticated features as it allows for supply contraction, even in the absence of participation in auctions. Further, the combination of the arbitrage auction with liquidity extension gives Malt a robust below-peg mechanism for facilitating stability by providing both real supply contraction with opportunities for participants to fairly profit by helping when the protocol is below peg.

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