How does Covenant work?

1. Covenant Markets

The Covenant Protocol operates Covenant Markets where a deposited Base Asset (e.g., ETH, WBTC, stETH, sUSDe) is split into two fungible claims:

• Leverage Coins provide holders with leveraged exposure to the Base Asset’s price and (where applicable) its native yield. Holders continuously pay funding to Yield Coin holders at a rate implied by the Yield Coin’s market price.

• Yield Coins are fully‑collateralized debt claims minted when a Base Asset is deposited into a Covenant Market. Yield Coins operate like tradeable perpetual, zero-coupon bonds with interest accrued at the rate implied by the Yield Coin’s market price.

2. Latent Swap AMM

Prices and interest in a given Covenant Market are set continuously by a built‑in, concave swap curve (known as the Latent Swap).

Traditional AMMs (like Uniswap) need both sides of a trading pair deposited as liquidity. Covenant is different: the protocol itself controls all Yield Coins, Leverage Coins, and Base Asset collateral. That means it can create a swap invariant that reflects the balance between Leverage Coins and Yield Coins rather than needing external LPs. The goal:

• Allow continuous swaps among Yield Coins, Leverage Coins, and Base Assets.

• Tie swap prices directly to the system’s Loan-to-Value (LTV) and therefore to the implied funding rate.

• Ensure leverage becomes more expensive as LTV rises (and cheaper as LTV falls).

The Latent Swap invariant is a concave curve defined over the at target values of Leverage Coints, Yield Coins, and Base Tokens:

$\left(V_L - L/\sqrt{P_a}\right)\left(V_Y- L\sqrt{P_b}\right)=L^2$,

$L=\frac{\sqrt{P_aP_b}}{\sqrt{P_b}-\sqrt{P_a}}$

Where:

• $V_L$ = value of Leverage Coins in the market ( at target)

• $V_Y$ = notional value of Yield Coins in the market

• $V_B$ = value of the Base Asset

• $P_a, P_b$ = price band parameters that concentrate liquidity within a defined range

Covenant’s Latent Swap AMM means that Covenant Markets are self‑balancing:

• When LTV rises (high leverage demand / low margin supply), Yield Coin prices fall, implied rates rise, and new lenders are drawn in—reducing LTV.

• When LTV falls (low leverage demand / abundant margin supply), Yield Coin prices rise, implied rates fall, and lenders withdraw—raising LTV.

LTV for a given market is defined as total value of Yield Coins outstanding in the market divided by total mark‑to‑market value of the Base Asset collateral in that market, i.e.:

$$LTV = \frac{V_Y}{V_B}$$

Below is a graphical representation of the self-balancing force of Covenant’s Latent Swap invariant in action.

Diagram 1: Yield-coin price and APY given market LTV (market defined as Pa=0.9, Pb=1.1, debt_duration=3 months, target APY=5%)

3. Leverage Coins

Leverage Coins provide leveraged exposure to the Base Asset’s price and (where applicable) native yield. In exchange for this leverage, Leverage Coin holders implicitly pay funding to Yield Coin holders at the APY implied by the Yield Coin price.

The value of all Leverage Coins in a given Covenant Market, B, is (approximately) the residual of the market’s Base Asset collateral value after accounting for the notional value of Margin Coins:

$V_L \approx V_B-V_Y$

where $V_L$ = total Leverage Coin value, $V_B$ = total Base Asset value and $V_Y$ = total Yield Coin value.

Note: we say ‘approximately’ above as this accounting equation only holds at the margin. In practice, because Margin Coins and Leverage Coins are priced continuously along the (concave) Latent Swap curve, the spot values of Margin and Leverage Coins combined will usually exceed the total Base Asset value in the collateral pool. The exact relationship among Margin Coin value, Leverage Coin value, and Base Asset collateral value is governed by the Latent Swap invariant, which ensures the market clears consistently.

The application of Leverage Coins is most easily conceptualized by examining use with different Base Asset types:

1. Volatile, non-yield-bearing assets (e.g. ETH, WBTC); and

2. Yield-bearing assets (e.g. stETH, sUSDe).

Base Asset Type	Leverage Coin effect	Return drivers
Volatile non-yield bearing assets (ETH, BTC)	Amplified price exposure	Directional price movement vs funding costs
Yield-bearing asset (stETH, sUSDe)	Leveraged carry on native yield + price exposure (where relevant)	(Collateral yield × leverage) – funding + price moves

3.1 Amplified price exposure: Use of Leverage Coins with volatile non-yield bearing Base Assets

Holding a Leverage Coin gives leveraged directional exposure to the Base Asset’s price.

• If the Base Asset goes up +1%, Leverage Coin value rises by more than +1%

• Effective leverage = 1 / (1 – LTV)

• If the Base Asset goes down –1%, the loss is amplified the same way.

Because Leverage Coin holders are implicitly paying funding to Yield Coin holders, they need asset price appreciation to outpace the funding costs (sometimes referred to as Funding Drag). The implicit funding cost borne by Leverage Coin holders isn’t a separate payment, but rather a dilution of the Leverage Coin’s share of the Base Asset collateral in a given Covenant Market.

To use a simple example, consider a Covenant Market with $100 in collateral:

• $80 represented by Yield Coins,

• $20 represented by Leverage Coins.

If the implied debt APY is, say, 10%, then over the next year the notional owed to Yield Coin holders will compound upward. Unless the collateral also grows in value (via price appreciation or native yield), that compounding comes out of the Leverage Coin’s slice.

• If collateral stays flat at $100, Yield Coin value increases (say, to $88), leaving only $12 for Leverage Coin holders.

• That $8 erosion is the funding cost being “felt” by Leverage Coin holders.

3.2 Leveraged carry (plus price exposure): Use of Leverage Coins with yield bearing assets

In this case, Leverage Coins not only track Base Asset price but also capture its native yield with leverage.

For example, if the LTV in a given Covenant Market is 80% (implying 5x effective leverage) Leverage Coin holders in this market will capture the yield (and price movements) of an underlying yield-bearing asset times 5, less the funding paid to Margin Coin holders.

This setup makes Leverage Coins behave like a tokenized carry instrument. Net carry is:

(Collateral Yield × Effective Leverage) − (Funding Cost)

In “cheap funding” environments (low Margin Coin APY), Leverage Coin holders can earn strong positive carry.

In “tight funding” environments (high Margin Coin APY), net carry may be negative, and returns depend more on Base Asset price moves.

Of course, Leverage Coin holders in Covenant Markets with yield bearing Base Assets are also subject to the Funding Drag phenomenon detailed in 2.1.3.1.

4. Perpetual Debt (Yield Coins)

Yield Coins in the Covenant Protocol operate according to a financial primitive known as Perpetual Debt. Perpetual Debt is designed as a continually refinancing zero-coupon bond: instead of expiring at a fixed maturity, the Yield Coin’s notional balance automatically grows or shrinks over time at a rate implied by its market price.

The price of a Yield Coin on the market $P_t$ determines its implied funding rate $r_t$ :

$$r_t=-\ln{ \left(P_t / D \right)}$$

where $r_t$ is the instantaneous rate and D is a “duration” constant. Under this formulation, it is intuitive that lower Margin Coin prices result in higher implied Yield Coin funding rates and higher Yield Coin price result in lower implied Yield Coin funding rates.

Perpetual Debt eliminates fixed maturities and governance-set rates. It allows Covenant to run continuous, liquid credit markets for any Base Asset where funding rates are set entirely by Margin Coin prices.

5. The sUSDz Yield Fund

An optional pooled lending product within the Covenant Protocol that allows margin providers (lenders) to gain diversified exposure across multiple Covenant Markets without needing to manage each Base Asset market individually.

• How it works: Lenders supply supported assets to the sUSDz Yield Fund. In return, they receive a receipt token ($sUSDz) that represents their share of the fund’s net asset value (NAV).

• What it holds: The sUSDz Yield Fund allocates capital across different Covenant Markets by holding a portfolio of Yield Coins denominated in USD. This diversification spreads exposure across many Base Assets and interest-rate environments.

• Why it exists: For lenders who don’t want to pick a single Base Asset market (DIY approach), the sUSDz Yield Fund provides a simple way to participate in Covenant’s credit marketplace while gaining broader, protocol-level risk and yield exposure.