Onchain CCP

Interest Rate Derivatives (IRDs) have emerged as a significant component, representing 80% of the derivative DeFi potential. However, managing risk and optimizing collateral in IRDs poses a major challenge. As the market grows, the need for a robust counterparty risk framework becomes increasingly evident. PIO Network is at the forefront of addressing this issue by reimagining central counterparty clearing (CCP) for DeFi.

Traditional finance has recognized the need for regulations like the Dodd-Frank Act, which mandates CCPs to mitigate risks associated with derivatives. In DeFi, however, such rules are absent.

Solving the Chicken and Egg Problem: Liquidity backstops are crucial for derivatives to create a liquid environment that makes backstopping liquidity provision safe. CCP is an incentive framework creating incentives to provide liquidity backstop.

CCPs are not designed to never default; instead, they aim to customize risk so that collateral efficiency becomes a function of risk. If the risk of loss exceeds the CCP fee earning expectancy, the Initial Margin (IM) efficiency can be decreased accordingly. For example, if the expected loss on a position is 5%, but the CCP fees are only 2%, the IM efficiency can be adjusted to ensure the CCP remains solvent.

The waterfall consists of several layers, each deployed as the account's health deteriorates:

1. Open Bidding: Liquidators submit liquidation proposals in anticipation of the Default Auction.

2. Dutch Auction: If open bidding is insufficient liquidation bids are immediately accepted at a given discount rate.

3. When the margin balance falls below a threshold level, positions are pushed onto a liquidity pool provided by backstop junior LPs.

4. Default Fund: At the last resort, losses are socialized by curtailing other users' potential profits and losses (PnL) and, in the last resort, by pushing positions at the bankruptcy price. This mechanism lives to prevent a single account from causing cascading failures.

Pricing Risk for LP Safety and Collateral Efficiency: The risk pricing model ensures that LPs remain safe while maintaining optimal collateral efficiency. The system adapts to various market conditions by adjusting a few key parameters. For example, if market volatility increases, the system automatically increases the required initial margin to maintain LP safety. Conversely, during periods of low volatility, the initial margin requirements can be relaxed to improve collateral efficiency.

This dynamic risk pricing allows PIO Network to strike a balance between safety and efficiency, ensuring that the system remains resilient under diverse market conditions. By continuously monitoring and adjusting risk parameters, PIO Network provides a secure and efficient environment for DeFi participants to engage in Interest Rate Derivatives.

Backstop LPs play a crucial role in providing liquidity to support the liquidation process. In return, they receive several benefits, including a portion of collected liquidation fees, exemption from liquidation fees when positions are pushed onto them, and the opportunity to have positions pushed at profit below market price. These incentives ensure that backstop LPs are adequately compensated for the risk they take on, encouraging participation and maintaining a healthy liquidity pool.