Risks (v2)

In V1, LPs were only exposed to a single pool, and all the Risks were limited to that particular pool. But as V2 diversifies the liquidity among different available pools for the deposited asset, this ensures better availability of liquidity across all the pools and also diversifies the risk for the liquidity provider.

This section is similar to that of Risks (v1).

Interest Rate Risk

Let us go through a loss-making trade:

The example assumes the entry interest to be 5% and the exit interest rate to be 7% at the time of exit. You held the position is 3 months. In this case, you would incur a loss of 0.78 Cash thus a negative APY of -3.13%.

Context: Risks subject to the change in Rates

Similar to how lenders may lose money if the rates increase, a borrower may also lose money if the rates decrease.

The liabilities on the side of the borrower would pile up faster if the interest rates keep dropping. If the LPs are in a net borrowing position they would face a similar effect. Moreover, if the interest rates are dropping, it may be due to the increased amount of Lending traders in the liquidity pool. This action would expose LPs to a greater borrowing position.

Impermanent Loss

In Defi, if you participate as a liquidity provider in a liquidity pool you would eventually end up with an asset that is less in demand. This shift in asset ratio would cause an unrealized loss compared to you holding the assets in your wallet than providing liquidity. This loss is known as Impermanent Loss.

Being a liquidity provider at Notional can be very beneficial if there is a huge borrowing demand as in this case the pool would be in a net Lending position (recall that LPs can get into a net fCash position based on trades in the liquidity pool), thus earning more yields as an LP.

With the above context, it is clear that if a user's portfolio has higher -ve fCash (obligation) than +ve fCash (claim on Cash), the user is in a net borrowing position. If the inequality is reversed, it would be a net lending position.

Context: Liquidity provider's portfolio

But if there is a huge Lending demand, the pool would act as a net borrower. A huge lending position can make the interest rates drop, thus creating greater liabilities for the borrower. We have explained the same thing from the perspective of a lender losing money if they exit early or if the rates increased.

Let us go through a loss-making trade:

The example assumes the entry interest to be 5% and the exit interest rate to be 7% at the time of exit. You held the position is 3 months. In this case, you would incur a loss of 0.78 Cash thus a negative APY of -3.13%.

Context: Risks subject to the change in Rates

Since the liquidity pool consists of cToken (Cash) fCash, the loss would be maximum if the pool is in a net borrowing position, the interest rates are dropping, and the supply rate for cToken is low. Impermanent Loss comes from the difference between the fixed rate nToken holders pay lenders and the variable Compound rate they receive for the loan duration.

Notional provides additional incentives in NOTE tokens to cover the impact of impermanent loss and it can be considered as an additional yield if LP doesn't suffer IL.

Maturity Risk

Longer-dated fCash is more sensitive to interest rate movements than shorter-dated fCash.

If we you compare the difference in value of the 6 Months fCash and 1 Year fCash resulting from the change in the interest rates, the difference in value for 1 Year fCash will be greater than that of 6 Month fCash.

For example, assume the rates to be 6% and the value of fCash for 1 Year maturity and 6 Month maturity would trun out to be 0.9418 & 0.9705. Now if we chnage the interst rate to 7% the value chnage to 0.9324 & 0.9657 respectively.

1 Year fCash shows a greater price chnage compared to the 6 Month fCash.

Context: Risks subject to the change in Rates

The change in the value of fCash due to the change in the exchange rate would be higher when the duration of bond maturity is higher. This coupled with Interest rate risk can impose risk on LP's assets.

Redemption Risk

In times of high utilization, nTokens can become temporarily unredeemable because the assets will be fully lent out to borrowers. This same risk will be posed for the Lender as well where they would not be able to exit their position.

If the liquidity pool is populated by the required assets it is still possible that nToken redemption or exiting lending positions can be expensive.

Though in these situations, the interest rates will become very high, it will attract lenders to the protocol and make nTokens redeemable again.

Opportunity Cost

There can be a time when there are no trades happening in the liquidity pool. Fee revenue would be nil in the case f o fees and the yield will be reduced to the NOTE.

No trades = No fees = Yield consisting only of NOTE token = Opportunity cost.