Leveraged Spot vs Perpetual Swaps: Cost and Risk

Available Liquidity for Leverage

Perpetual Protocols

Perpetual protocols typically require a debt pool to allow traders to open positions. Most on-chain perpetual protocols implement this by allowing depositors to provide liquidity to the debt pool in exchange for trading fees (and incentives).

Similar to decentralized exchanges and the risk of impermanent loss, depositors on perpetual protocols are exposed to asset risk. This occurs when the Open Interest (the amount of non-settled positions) in one direction is materially greater than the other. For example, if there was a greater amount of short positions than long positions, depositors would have to pay traders if the price of the underlying asset were to fall.

To manage this risk, perpetual protocols typically use risk frameworks to place caps on the amount of Open Interest on different assets. This can be a limiting factor in creating large leveraged positions on exotic assets.

While earlier implementations of perpetual protocols used a combined debt pool for all assets, newer implementations have fragmented debt pools to allow depositors to limit their risk to asset classes.

Nolus

Contrastingly, Nolus uses a global liquidity pool that operates similarly to a money market. Users borrow assets from the Liquidity Providers’ Pool which is used to purchase an additional amount of their desired asset (i.e., creating a leveraged position).

The underlying model manages the purchases made and means that adverse movements can be quickly treated by partial liquidations (or liquidations) if necessary.

Depositors are still exposed to some short-term risks under this model. However, rather than being exposed to a mismatch in Open Interest, Nolus is vulnerable to a fast decrease in price that surpasses liquidation points. If this were to happen, the value of the assets post-liquidation would be lower than the debt.

To mitigate against this risk, Nolus uses an enshrined oracle system for rapid pricing updates and uses a collection of decentralized exchanges within the Cosmos ecosystem to perform necessary liquidations.

Additionally, loans are exposed to liquidations at a 90% max LTV ratio. Therefore, if the liquidation is executed between 90% and 100% LTV, a liquidation can occur with lower risk to depositors. However, if the liquidation was to take place with an LTV over 100%, Nolus’ reserve contracts would be required to cover the potential bad debt to depositors.

Fee Structure

Perpetual Protocols

These protocols will heavily rely on funding rates as a means of trying to equalize Open Interest in both directions for any asset. As noted above, as the skew increases, the risk to depositors also increases.

If a market was long-heavy, traders with a long position must pay a funding rate to maintain their position. In the same market, traders would be incentivized to open a short position by being paid a funding rate.

While this can be sufficient for maintaining an “even” market, it means that for some durations of time, traders can be “locked out” from opening positions due to the adverse impact of high funding rate costs.

Nolus

Nolus charges a fixed interest rate to borrowers. This is calculated relative to the total utilization of the Liquidity Providers’ Pool. As utilization increases, the total interest increases. It should be noted that this is capped at an optimal utilization threshold to prevent interest rates from skyrocketing to exorbitant amounts for borrowers, also providing them with some additional confidence and predictability. This is irrespective of the specific position (asset or direction).

Borrowers on Nolus face significant exposure to on-chain liquidity and slippage levels. DeFi Leases purchase the required assets from integrated decentralized exchanges. This means that the cost of slippage is a material component of total fees. The greater the on-chain liquidity for an asset, the cheaper it would be to purchase the required assets which would reduce the total cost of the DeFi Lease.

The Opportunity

Nolus primarily operates in the Cosmos ecosystem where there is a significant abundance of new cryptocurrencies.

As explained above, we can see why traditional on-chain perpetual protocols would struggle to provide efficient markets for assets with lower market caps. This is because opening moderate positions would provide significant volatility to a market and create a large skew (and an associated large funding rate increase).

Nolus provides a significant advantage here as it maintains alignment with tokens as they gain effectiveness as liquidity depth increases (and thus slippage decreases). This synergy is demonstrable as this is a fundamental target for most tokens.

Conclusion

Nolus has many similarities with on-chain perpetual protocols. However, there are some fundamental differences between a liquidity provision perspective and a trading perspective that will make it more attractive for different sets of DeFi users.

We think that Nolus will excel in the Cosmos ecosystem and provide a strong platform for traders of Cosmos tokens by being able to offer cheaper and safer leveraged positions than traditional on-chain perpetual protocols.