Understanding Liquidity Notes
Fixed-maturity derivative primitives designed for sustainable on-chain liquidity
Liquidity Notes were first detailed in published research by Jan Pevzner of Exchequer Finance. This framework pioneers the adaptation of Black-Scholes to the distinct characteristics of DeFi AMM liquidity positions.
Engineered Features
Principal Protection
The notes are structured to offer a degree of downside protection on the principal, a feature achieved by incorporating specific LP option configurations into the note's composition.
LP-Based Upside
Noteholders have exposure to the potential appreciation of the underlying LP position, including fees generated, beyond a pre-defined strike. The characteristics of this exposure are informed by our research into LP token behavior.
Sustainable Yield Source
Additional yield can be generated from the efficiently structured, project-owned LP collateral that backs the notes. This mechanism avoids reliance on continuous token emissions for yield generation.
Operational Mechanics
Issuance & Capital Formation
Projects issue Liquidity Notes to secure capital (e.g., USDC, ETH) from investors.
Collateralization with Project-Owned Liquidity
A significant portion of the raised capital is programmatically paired with the project's own treasury tokens to establish an LP position. This LP position, often larger than the note's face value due to the capital structure, serves as the primary collateral. This can create up to double the liquidity for the same amount of project treasury tokens committed.
Maturity & Settlement
At maturity, noteholders are paid according to the note's terms. The remaining project-owned LP collateral is then fully available to the project, enhancing its balance sheet without ongoing emissions.
Considerations for DeFi Projects
Reduced Intermediary Costs
Provides a pathway to liquidity that can lessen dependence on centralized listing fees and market maker expenses.
Non-Inflationary Liquidity Growth
Enables the creation of Protocol-Owned Liquidity without resorting to dilutive token incentive programs.
Long-Term Alignment
The structure is designed to attract liquidity providers with a longer-term perspective.
Efficient Treasury Utilization
Allows projects to leverage their existing token assets more effectively to build substantial liquidity.
For Capital Allocators
Exposure to Project Fundamentals
Offers a way to participate in a project's growth, with returns linked to tangible LP performance.
Defined Risk Parameters
The instruments are designed with quantifiable risk and payout profiles, leveraging the underlying financial engineering of the LP-Derivatives framework. This includes adapting concepts like power options to the DeFi context, where LP options behave as "square-root options".
Grounded in Research
The development of Liquidity Notes and the supporting framework is the result of extensive research into DeFi market structures, LP risk management, and the application of derivative pricing models to this new asset class.
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