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Liquidity (TVL)
Liquidity, often referred to as Total Value Locked (TVL), represents the funds available in a protocol that are used to settle potential payouts for traders. Liquidity fluctuates as traders open and close their positions. Traders pay fees when they open positions, and the liquidity pool absorbs any profits or losses resulting from their trades. Users can contribute liquidity by depositing funds, for which they receive LP (Liquidity Provider) tokens. These tokens represent their share of the protocol's liquidity and can be redeemed later to withdraw their funds.
For example, if the protocol has $1,000 in liquidity, traders can collectively open positions totaling up to $1,000.
To maintain a balanced market, there is a cap on the total position size (open interest) for both long and short positions. The total size of long or short positions can only be up to half of the available liquidity. This structure ensures that the protocol remains solvent and helps manage risk by keeping long and short positions balanced against the available liquidity.
For instance, if there is $1,000 in liquidity, traders can open long positions totaling up to $500 and short positions totaling up to $500.
To view the available liquidity formula and an example, visit: Calculating Available Liquidity.
LP Tokens
When users provide liquidity to the protocol, they receive LP (Liquidity Provider) tokens in return. The value of these tokens can fluctuate as the protocol's liquidity changes. LP tokens can be redeemed to withdraw liquidity, and their value reflects the share of the total liquidity they represent.
To view the LP token price formula and an example, visit: Calculating LP Token Price.
Liquidity must cover all open positions. For instance, if the total liquidity is $1,000 and the open interest (total size of all open positions) is $500, only $500 worth of liquidity is available for withdrawal. The remaining liquidity can be withdrawn once traders close their positions, reducing the total open interest. This ensures that liquidity is always sufficient to cover active trades, protecting both liquidity providers and traders.
Open Interest
Open interest refers to the total value of all active positions (both long and short) in the market. As open interest grows, more capital is used in trades, which directly leads to higher fees generated by the protocol.
Open interest cannot exceed the available liquidity. Traders are unable to open additional positions (and thus increase open interest) if it would surpass the protocol's liquidity. This mechanism protects the protocol from overleveraging, ensuring that the platform remains solvent and capable of covering all open positions.
Total Unrealized Profit and Loss
Total unrealized profit and loss (P&L) represents the combined value of all open positions. It indicates the amount that the liquidity pool would need to absorb if all positions were to be closed simultaneously. For instance, a negative unrealized P&L would result in an increase in liquidity, while a positive unrealized P&L would lead to a decrease as traders receive payouts from the liquidity pool.
Liquidations
A trader's position can be liquidated if its value drops below 16.66% (1/6) of the collateral they provided. If you liquidate someone else's position, you earn 1% of their collateral as a liquidation fee.
For example, if a trader opens a position with $120 in collateral and its value falls below $20, you can liquidate it and receive $1.20 as a liquidation fee.
The remaining value of a liquidated position is not transferred to the trader; instead, it is added to the protocol's liquidity. If you suspect your position is at risk of being liquidated, it’s advisable to close it before it reaches the liquidation threshold to avoid losing remaining value.