It is not simple to implement leverage in cryptosystems. A significant number of today's systems make use of either middle-term solutions or significant off-chain components. Because of this, crypto leverage trading does not share the composability and permissionless characteristics of other DeFi products.

A forthcoming derivatives exchange (DEX) called InfinityPools would provide traders with limitless leverage on any asset pair, in addition to eliminating the need for oracles, liquidations, and counterparty risk. These are big statements, and if they are shown to be true, they would certainly be a major contribution to the realm of decentralized leverage trading. Let's have a peek at the inner workings of InfinityPools and see how it manages to provide such outstanding features.

The current leverage in DeFi

The way leveraged trading normally works is by enabling traders to borrow multiple of the cash collateral they have in order to trade with that borrowed money. This puts the protocol at risk of being negatively affected by traders. Price oracles will cause liquidations, which will unwind lost transactions before the protocol goes into debt. Users may incur additional costs as a result of these efforts, and they are not reliable in all severe situations.

Making sure that traders make money is a challenging endeavor in and of itself. In order to settle the long tail of leverage instruments, procedures need to be creative since they do not have access to the substantial credit markets of legacy finance. About the available choices, this is really simple. The contract for the options is first collateralized with the underlying asset via the options protocols. This results in additional difficulties regarding scalability and profitability for Liquidity Providers (LPs), despite the fact that the leverage mechanism itself is very straightforward.

The long tail is ensured by synthetic leverage platforms like Synthetix, GMX, and Gains Network since they function on the premise that the firm as a whole is a continuing concern. Although Gains Network generates a house advantage via a series of constraints, Synthetix employs an overcollateralized loan pool as a temporary counterparty. As long as the business as a whole is profitable, there should be no cause for concern about individual trades. The maintenance of the protocol is financially supported by all platform stakeholders. This eliminates the combinability that gives options their considerable strength as a tool.

dYdX produces an environment that is analogous to that of a CEX by virtue of its financing mechanism, the use of an external spot price to index against perp contract pricing, the utilization of advanced order types, and the utilization of an off-chain matching engine. dYdX has been the most popular DEX for leverage trading up to this point; however, it does not have the composability or transparency of a permissionless, on-chain protocol.

It is abundantly evident that there is a significant need for a novel primitive that has the capacity to collateralize leverage transactions on an individual level. This would eliminate the need to rely on oracles and liquidations in order to safeguard LPs. And this is where InfinityPools comes into play.

InfinityPools mechanism

This coming March, the testnet version of InfinityPools, a leverage trading decentralized exchange, will go live. The basic layer of InfinityPools is a standalone concentrated liquidity automated matching market (CLMM) called the float pool. Its model is quite similar to Uniswap v3. LPs have the option of either depositing liquidity directly, similar to how they do on the current version of Uniswap v3, or depositing an existing UNI v3 LP token, in which case the protocol will unwind and convert the token on the user's behalf. Lend[ing] out slices of LP holdings to traders is one of the ways that the float pool facilitates leveraged trading on top. This method entails the formation of a private swapper contract for each deal. Inside this contract, the trader has the ability to carry out an infinite number of feeless swaps at the strike price.

The reserves of the LP token, which are protected by the protocol used by InfinityPools, are being used to guarantee the leveraged trade. When it comes to facilitating optimal lending and borrowing between traders and LPs, InfinityPools makes use of an off-chain matching engine. Traders have the flexibility to repay the loan using any combination of tokens throughout the LP curve, and InfinityPools will guarantee that the LPs get the appropriate proportion of tokens.

Trades with a leverage ratio of 1-40x are required to pay an up-front fixed-rate loan. Trades with leverage greater than 40x need the rolling over of variable loans, which are more costly. As long as the trader continues to pay the interest, the position will stay open. When a deal is closed, it may be done atomically on any DEX or DEX aggregator; however, depending on the trading venue that was utilized, slippage and spot trading costs may be incurred.

InfinityPools may most accurately be described as a protocol for perpetual options, and its user interface is designed with traders of perpetual futures in mind.

Consider Uniswap as an underlying protocol

InfinityPools option explained

Source: Projectfinance

In academic circles, Uniswap v3 is often compared to a variety of options protocols. The payoffs from the liquidity provision on Uniswap are extremely comparable to those of well-known option strategies, although the premiums are unclear. For instance, in a cash-secured put, the investor puts up cash to guarantee that the underlying asset will be purchased at the strike price, and in exchange, the investor receives an upfront premium. The maximum profit that a trader may make is equal to the premium, and any decline in the price of the underlying asset first reduces the value of the premium before it results in a loss. If the trader does not use hedging, they are exposed to a limitless amount of risk.

If we suppose that the price of ETH is present at $1,000, we can create a scenario that is similar to this one by contributing 1,000 USDC worth of single-sided liquidity to the ETH/USDC Uniswap pool in the range of $900 and $1,000 ETH. The LP is not concerned with possible gains to the upside and is instead concentrating on the price movement of ETH in the range of $900 to $1,000. The LP most likely has one of these two purposes or goals in mind:

The trader anticipates that ETH will remain rather steady, moving about within the LP range and that they will continue to generate trading fees. The LP will most likely try to close the position somewhere around one thousand dollars worth of ETH in order to neatly take in fee money.

The trader is interested in purchasing ETH at $900, but he anticipates that it will fall in price in the near future and either want to acquire a better price or expects it to drop. A range order is what you have here, and the fees collected by the LP position act as a rebate to the lower strike price.

The most important thing to take away from this is that the LP is OK with owning ETH or a blend of ETH and USDC, and it is not worried about ETH prices that are higher than 1,000 USDC.

The leverage facilitation

infinity mechanism

Source: InfinityPools whitepaper

By allowing LPs to lend out their LP positions to leverage traders, InfinityPools gives them the opportunity to capitalize on the gain that would otherwise go unused in a traditional CLMM. A leverage trader who is interested in going long ETH can borrow the LP position shown in the previous example and then sell 1,000 USDC in exchange for one ETH.

Due to the fact that the payout of the LP position is very compatible with spot ETH exposure, the repayment of the LP loan is a rather uncomplicated process. If the price of ETH falls below the LP range (less than $900), the LP position will consist of 1.11 ETH (1,000 divided by 900 equals 1.11). When determining whether or not ETH is within range, there are extra factors to take into consideration; nevertheless, for simplicity, the most it may be is 1 ETH plus 99 USDC. When ETH is trading at a price that is higher than the range, the LP position will consist of 1,000 USDC.

Because the trader borrowed the LP position and then sold it for ETH, and because 99 USDC will be able to acquire at least.11 ETH whenever it trades for less than $900, 99 USDC is adequate collateral to make the LP whole in all possible circumstances. The creation of a completely collateralized spot ETH position, which is achieved through the reconciliation of trader and LP payoffs, eliminates the requirement for liquidations.

The leverage resulting from having 99 USDC as collateral and having exposure to 1 ETH at $1,000 is 10 times. This procedure is repeated by InfinityPools so that it can provide leverage on all asset pairs. More leverage can be achieved with tick ranges that are closer together. For instance, the identical setup could accommodate a 1,000x leverage trade if the LP range was set to be between 999 and 1,000 ETH/USDC.

When an LP position is lent out, the interest earned on the loan is what is counted as revenue rather than the swap fees. The interest rates that traders pay to borrow money bring the returns on lent-out principal closer to being equal to the implied volatility of that piece of the portfolio. When the utilization rate is high, LPs on InfinityPools switch between receiving variable returns based on volume and continuous returns. Although if the LP compensation switches from trading fees to loan interest, the composition of the underlying LP basket stays the same, which is a crucial point to keep in mind.

This model is advantageous in many ways for traders as well as LPs. The approach is exceptionally efficient with its use of capital, which enables limited partners to earn a steady yield even when the fund is not actively trading. If you have a narrow LP position that is able to serve 1,000x leverage, you can also utilize it to service any degree of leverage that is lower than that.

This process gives the impression that the LP is merely selling a call option, using borrower interest as the premium. This is an admitted flaw in the explanation. Even though InfinityPools is not composed wholly of choices or perps, it does have elements of each of these things and can be loosely categorized as eternal options. In contrast to normal options, liquidity is not fixed across strikes or expiration dates. This allows traders to avoid the fragmentation of liquidity that is frequently caused by options protocols.

Several fascinating projects, each in their own unique way, are now working to implement perpetual alternatives. GammaSwap is developing products that are focused on volatility by providing users with the ability to borrow LP positions for the constant-function market makers (CFMMs). On top of Uniswap v3, Panoptic is developing a powerful toolset for experienced users, which will allow these users to generate a wide variety of alternative reward structures. The user experience (UX) for going long and short in InfinityPools is designed to be as comparable as possible to that of a perps exchange. The option premium is structured as rolling fixed-term loans; this helps to simulate the financing rate structure of perpetual futures contracts.

InfinityPools' advantages

It will be much easier to grasp the claims made by the project now that we have a better understanding of the mechanics of concentrated liquidity LP positions and how they are similar to options strategies.

Infinite Leverage - The only thing that can cap your leverage is the tick range. More leverage can be achieved with shorter tick ranges. On InfinityPools version 1, leverage of 2,000x will be readily available, and there is the possibility that this number will eventually be raised even further.

Any Asset — Because InfinityPools is built on a permissionless concentrated liquidity market maker (CLMM) and underwrites leverage with LP tokens, it is able to offer leverage on any asset pair that users choose to provide liquidity for. This gives users more control over the assets they trade.

No Counterparty Risk — This risk is eliminated by the fact that traders are required to borrow LP tokens. The protocol safeguards the assets and ensures that the LP will be repaid in full when the loan term comes to an end.

No Liquidations - this is a shrewd marketing strategy because, despite the name, positions can still be closed out when the price moves in the trader's favor even though there are no liquidations. Users are able to keep their out-of-the-money positions while continuing to pay interest on those positions during the term of the loan.

Risks associated

It appears that InfinityPools will have little trouble achieving product-market fit for tokens with a tiny market valuation. When traffic is lower and LPs are more concerned about limiting impermanent loss, we have seen in the past that the value proposition of smaller DEXs (like Bancor) is strengthened for this niche. In this respect, InfinityPools will provide traders with the opportunity to profit from the best of both worlds, as LP returns will be closer to indicated volatility while at the same time receiving continuous income.

On the other hand, it might be challenging for InfinityPools to establish itself in significant asset pair markets. Leverage trades will almost certainly have borrow rates that are higher than the average, and they will be required to interact with spot DEXs in order to complete lucrative trading. Because of this, it is likely that InfinityPools will have fees that are slightly higher than those of its key competitors such as Synthetix, dYdX, and CEXs. The competitive landscape will be partially determined by how highly the market values the ability to trade without being subject to liquidation and whether or not it is willing to compensate for the higher expenses.

Although it appears that the value proposition for LPs is straightforward, we have never before witnessed a CLMM bootstrap liquidity from nothing. It took Uniswap v3 a considerable amount of time to populate the v3 AMM, despite having $9 billion TVL on an existing version 2 and an easy transfer mechanism. It wasn't until January 2022 that Uniswap v3 became the predominant portion of the company's total TVL.

Now that people are much more used to the complexities of concentrated liquidity, InfinityPools will enable users to deposit UNI v3 LP NFTs in addition to raw liquidity. This is because people are now much more acclimated to dealing with concentrated liquidity. And yet, InfinityPools does not have the convenience of an already existing version 2 to make the process simpler.

In May, Uniswap's business license will come to an end, and rumors about a possible v4 are continuing to circulate. Uniswap v3 intruded on projects that were near its territory and competed with Curve for reliable swap volume. Since the very beginning, Uniswap has maintained a firm hold on the DEX market sector. March of 2021 was the most recent month in which Uniswap's market share was lower than 50%.

DEX market share

Source: Dune Analytics

Even with the release of Uniswap version 4, InfinityPools has an uphill battle to increase its market share. Even though InfinityPools is a leveraged trading DEX with a product offering that is in the middle of what dYdX and Uniswap have to offer, it is primarily an AMM that focuses on focused liquidity. It will compete with Uniswap for the same amount of liquidity, and the amount of liquidity it can attract will determine the maximum amount of open interest it can have.

Concerns have been raised by certain individuals regarding the possibility that malevolent actors could employ InfinityPools swaps as quick loans with a longer repayment period. There is a higher possibility for exploits because these flash loans can span numerous blocks and can be repaid in either asset. Despite the fact that this might be the case, ineffective protocol designs will eventually be exploited or removed from the market.

Conclusion

In the event that InfinityPools is successful, the repercussions could be rather serious. The fact that traders have the capacity to obtain leverage on tiny cap tokens might assist ameliorate what are often times difficult liquidity circumstances. Due to the fact that loan rates are determined by the market, it is likely that LP returns will trend closer to implied volatility.

Also, gaining access to leverage on tokens that aren't listed on CEXs is a potential step toward severing the structural connection that exists between DeFi and CeFi. If DEXs continue to rely on CEXs for such a major amount of the product stack, then it is impossible for them to hope to overtake CEXs. Because it can be difficult to short an asset or gain leverage on-chain, many aggressive token economics systems go unpunished until they are listed on CEXs. This is because shorting an asset or getting leverage on-chain can be difficult. When a project is listed on CEX, it is a significant achievement for the team and marks a turning point in the price action of the token.

On top of infinity pools, there are a lot of different building options available. The oracle-free and liquidation-free trading experience is attracting a lot of attention, but the permissionless asset listing and the potential for composability could be the components that have the most significant influence. Once leverage is more easily accessible, various financial instruments, such as stablecoins for foreign currencies, future yield tokens, and interest rate swaps, could all gain traction. In the future, more flexible structured product vaults will be developed on top of InfinityPools, which will make the provision of liquidity even simpler.

InfinityPools is leading the way in the development of advanced order types that are powered by LP token borrowing and manipulation, which will improve the LP user experience. These projects will play an important part in the maturation of DeFi and will enable it to build out a more complete ecosystem that is less dependent on CEXs. This will allow DeFi to become less dependent on CEXs.

Disclaimer:
This article is intended for and only to be used for reference purposes only. No such information provided constitutes advice or a recommendation that any investment or trading strategy is suitable for any specific name.

InfinityPools: Unlimited leverage without liquidation