Coverage Ratio: What is it and Why Is it Healthy for your Deposits
Wombat uses Coverage Ratio to manage our liquidity pools. This fundamental change in our pool design allows us to offer the best slippage and single-sided staking since our liquidity pools can reach and maintain equilibrium much easier than our market peers. In this article, we will explain the theory behind this concept and provide examples of how it functions within Wombat Exchange.
Coverage Ratio 101
Coverage Ratio is a common concept in traditional finance used to describe a company’s ability to cover its liabilities with its assets (assets divided by liabilities). In Wombat’s case, each stablecoin is its own company, and each coin has its own Coverage Ratio. You can think of the Coverage Ratio as a health indicator for Wombat’s liquidity pools. A high coverage ratio means there are more assets than liabilities and indicates a lower risk of default.
Consider the following example:
The BUSD liquidity pool initially contains 1000 BUSD (i.e., 1000 assets and liabilities). It receives a deposit of 200 BUSD before 400 BUSD is swapped away with USDT.
When a deposit is made, both the asset and liability of BUSD will increase by the same amount since Wombat has gained BUSD for swapping (asset) and owes BUSD to the depositor (liability). The BUSD Coverage Ratio remains unchanged.
When a swap occurs, the assets for USDT will increase by 400, and the assets for BUSD will decrease by 400, which results in an increase in USDT Coverage Ratio and a decrease in BUSD Coverage Ratio.
Deposit Gains & Withdrawal Fees
Maintaining an equilibrium state is the aim. Since Wombat’s asset-liability management design could potentially lead to withdrawal arbitrage which drains funds from the pool, an incentive system was implemented. Users will receive deposit gains as their action helps bring the pool closer to its equilibrium state. A withdrawal fee, on the other hand, discourages withdrawal arbitrage. LPs will not be affected as the gains and fees are not a significant amount unless the pool is extremely out of balance. Get the fees breakdown on https://docs.wombat.exchange/docs/concepts/fees.
Coverage Ratio vs. APR
Coverage Ratio and APR are completely different indicators.
The Coverage Ratio is an indicator of liquidity pool health and is affected by pool size and transactions.
APR is an estimation of annual rewards and is affected by your pool allocation, pool weight, and total pool weight. Click here for more information on how to calculate your APR on Wombat!
Equilibrium Coverage Ratio
Wombat also protects our users with an Equilibrium Coverage Ratio (ECR) — an overarching Coverage Ratio of all of our liquidity pools. It allows us to monitor the health of our protocol and manages risk (preemptively in extreme cases). Should a black swan event offset the ECR, the system prevents all swapping transactions to allow depositors to recover their funds.
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