Introduction

Covenant Liquid is a key building block in the Covenant platform for transforming risk.

Markets

Covenant markets are defined by a base-asset, an oracle source (pricing the base asset in terms of a quote unit) and a debt duration. Users deposit base-assets into a Covenant market, and mint leverage-coins and yield-coins.

Covenant markets effectively split the value (and risk) of the base-asset in two:

1. Yield-coin: a safer portion which accrues interest and is denominated in quote units

2. Leverage-coin: a riskier portion that retains the difference in value between all the base asset liquidity in the market, and all the yield-coin value minted by the market

These coins are fungible, tradeable, and composable - creating a capital efficient transformation of the base-asset risk. They follow the ERC4262 tokenized vault standard, and are fully collateralized and redeemable by the underlying base-asset.

Diagram 1. Leverage-coins and yield-coins are fully backed by the base asset, and split its value and risk.

Perpetual Debt

The yield-coins accrue interest based on their market price, which is described in more detail in the Perpetual Debt WhitePaper. The debt notional $N$ compounds value over time as follows (for a constant price p, and debt duration D):

$$N_t = N_oe^{-\frac{t \ln(p)}{D}}$$

Latent Swap DEX

Traditional DEXs require liquidity providers to deposit token pairs for the exchange to work. Covenant markets, on the other hand, fully control all the existing leverage-coins and yield-coins, and can thus use all the liquidity in the market to enable swap operations.

When a user swaps yield-coins for leverage-coins, the protocol burns supplied yield-coins and mints new leverage-coins. This requires a convex swap curve, ensuring that as more coins of one type exist in the market (e.g., leverage-coins), further issuance becomes progressively more expensive.

For this we introduce the latent swap invariant, a convex swap curve that concentrates liquidity between two price points $P_a$ and $P_b$.

$$\left(Vx - \frac{L}{\sqrt{P_a}}\right)\left(Vy - L\sqrt{P_b}\right)=L^2$$

Here $V_x$ represents the notional value of yield-coins, $V_y$ the value of leverage-coins, and $L$ is proportional to the base-asset's total value. This invariant enables consistent swaps among leverage-coins, yield-coins, and base-assets while accurately reflecting exchange rates and price slippage given market liquidity.

Effectively, latent swap markets operate as perpetual decentralized lending exchanges, where debt pricing and yields correlate directly with market loan-to-value (LTV), analogous to crypto lending markets' utilization ratio rate curves.

Diagram 2: Yield-coin price and APY given market LTV (market defined as Pa=0.9, Pb=1.1, debt_duration=3 months, target APY=5%)

Additional details on the Latent Swap invariant will be posted in an upcoming whitepaper.

Market dynamics

Market participants are incentivized to mint yield-coins when interest rates are high, purchasing debt at a discount, and to burn yield-coins when rates are low, selling at a premium. In high LTV scenarios, this incentive structure naturally encourages debt reduction, stabilizing the market's leverage exposure.

Rate matching and volatility cost

Without external intervention, markets self-stabilize at a point where yield-coin APY's equals the base token's average return divided by the LTV. However, markets are not static and their is a cost to leverage token holders for actions taken in the market. Base token volatility translates into mean reverting debt token volatility - where external actors can extract value through statistical arbitrage. This is known as volatility cost (or volatility decay).