Not financial advice; this article is intended for research/educational purposes only. Footnotes are available at the end of the article.

TL;DR

Overlay Protocol has governance-set payoff and open interest caps that are specific to each Overlay market. These caps help the protocol minimize the impact of heavy tail behavior of some assets. Circuit Breakers act as an additional layer of protection that restrict the notional size of new positions when OVL printing (to pay out PnL) in the recent past has been excessive.

Introduction

Overlay will offer markets to its users without traditional counterparties taking the other side of the position. Positions taken on Overlay markets will resemble perpetual futures in that there is no underlying asset to be delivered on the settlement date like a traditional futures contract.

However, Overlay markets will not resemble some traditional models of crypto perpetual futures markets like:
(i) crypto exchanges that rely on swap-based counterparties (including market makers) in order to seed liquidity into their markets, or
(ii) on-chain derivative protocols that use LPs¹ to seed liquidity into liquidity pools² that users then build positions against.

Overlay essentially uses a portion of the OVL market cap to bootstrap liquidity into any Overlay market. To enter a position, a user locks OVL as collateral and the user’s PnL³ is also paid out in OVL. OVL is minted by the protocol if a position is in profit and is burned if it is at a loss. This enables Overlay markets to have deep liquidity without the need for LPs or traditional swap-based counterparties. In this mechanism, the role of a traditional counterparty is assumed by passive OVL holders in case of an imbalance liability (i.e. an imbalance between open interest of longs and shorts). Potential OVL supply inflation risks are minimized by the circuit breaker mechanism, explained below.

The mechanism to seed liquidity on Overlay provides the protocol with certain benefits, but also has certain downsides that the protocol must minimize. In order to protect the protocol and the OVL token from the damage that a heavy tail distribution⁴ of an asset may cause, Overlay has chosen to have payoff caps and open interest caps. This is one of the ways Overlay tries to address the issue of imbalance liability and how it affects the protocol/ passive token holders. We will now discuss below what these caps are and how they apply.

Payoff Cap

Overlay markets will have a “per-position” payoff cap that will limit the PnL of each position on the protocol (denoted as Cp). This static per-position cap will be determined by the community/DAO through a formal governance process and will be specific to each market that the protocol will add. With longer tail assets, governance could choose a lower cap and vice versa.

In markets based on long tail price feeds, the payoff cap enables:
(i) the protocol to avoid a theoretically infinite payout on any particular position, and
(ii) the protocol to quantify the risk associated with each market in an automated fashion, based on the Cp determined by the DAO.

The figure below illustrates how, in certain scenarios, the protocol could theoretically have to print an infinite amount of OVL (to pay out PnL) on a single position if a payoff cap is not used. It also shows how this payoff cap deterministically limits the payoff.

Open Interest Cap

Overlay markets will also have a “per market” cap on open interest (OI)⁵; the cap will be on the aggregate OI for the long and short sides of each market. This OI cap will be a function of CQ, a per market notional cap decided by the community/DAO through a governance process. This cap is required despite the existence of the payoff cap as the payoff cap does not work unless used in conjunction with an OI cap: users could simply bypass the payoff cap by entering multiple positions on the same market.

Whenever a new position is about to be entered on an Overlay market, the protocol / smart contract ensures that the amount of OI being added to the market through this new position does not cause the aggregate OI of the entire market to exceed the OI cap imposed on the market.

Setting the CQ parameter through governance helps the protocol quantify inflation risk, that is, the amount of OVL that the protocol will have to mint in case of a worst-case scenario. This hypothetical worst-case scenario involves the imbalance liability (the difference in OI between longs and shorts) being completely skewed towards one side (long or short side of the market).

By quantifying the inflation risk in this worst-case scenario, Overlay will be aware of the maximum amount of OVL that is allowed to be printed. This per-market risk quantification is a function of CQ. Thus, CQ must be calibrated in governance based on the amount of OVL inflation the DAO is willing to tolerate for a particular market. This mechanism design thus protects the protocol even if a black swan type event occurs in a particular market.

Circuit Breaker

The circuit breaker mechanism gives an extra layer of protection to Overlay, in addition to the payoff cap and OI cap mechanisms described above. The circuit breaker allows a market to cool off in case there have been large payouts (in the form of OVL printing) during the recent past.

The circuit breaker mechanism gets triggered for a particular market if there has been a higher-than-expected inflation rate in a certain past rolling period of time (caused by printing of OVL by the protocol to pay out users). Using the static notional OI cap CQ, the protocol calculates an expected per-market inflation rate (represented as Iα) for the last Tα period of time. If the actual/realized interest rate (represented as IR) during this period exceeds Iα, the circuit breaker mechanism jumps into action.

The circuit breaker works by adjusting the per-market notional OI cap (CQ) for a particular period of time so as to limit the possible notional size of new positions offered by the market till the market cools down. This is done by calculating IE, the effective inflation rate target⁶ at time t. IE is then used to calculate a new effective OI cap which acts as the circuit breaker till inflation reaches a desirable level again.

Conclusion

Overlay’s design is such that there are no traditional counterparties to each position taken on Overlay markets — PnL is realized in the form of printing or burring of OVL tokens. Essentially, the entire market cap of the protocol acts as a counterparty to users on the protocol that have caused an imbalance liability (a difference in OI between longs and shorts or vice versa). While this enables Overlay to do really cool things like offer markets based on data streams like inflation or sneaker prices, it also opens up the protocol to existence risks due to infinite inflation being possible theoretically.

Overlay uses the payoff cap, OI cap, and circuit breaker mechanisms to counter this risk. These mechanisms quantify the risk taken by the protocol due to the protocol offering a particular market. They also help cap the inflation theoretically possible by limiting payout using the aforementioned caps. These mechanisms are imperative to mitigate the risks posed to the very existence of Overlay.

Footnotes

[1] A Liquidity Provider (LP) is someone who seeds liquidity into a pool by depositing digital assets (usually two) in order to enable decentralized exchanges to offer trading on the digital assets. Liquidity providers receive fees in exchange for providing liquidity and taking on price risk and impermanent loss risk.

[2] A Liquidity Pool is a pool of digital assets where LPs collectively deposit their digital assets (usually two) so that decentralized exchanges can offer markets based on the digital assets deposited.

[3] PnL stands for profit and loss and it describes the change in the value of a position taken by a user. If the position is still open, the profit/loss is unrealized; whereas, if the position has been closed the profit/loss has been realized by the user.

[4] “A heavy tailed distribution has a tail that’s heavier than an exponential distribution” (Bryson, 1974). Heavy tail distributions have a higher probability of huge unforeseen events occurring (and are thus risky).

[5] Open Interest is simply the total number of open futures contracts/positions that have not yet been settled on a particular market. OI is also often represented in terms of the dollar value of the open futures positions of a market. Some users use OI along with volume to gauge market sentiment and inform their positions.

[6] This is the desired inflation rate Iα adjusted for the difference between the realized rate over the last Tα period and the desired rate.