This is part 2 of our research report on HyperLiquid. You can find part 1 here where we go over introduction, high level architecture and trading strategies. Part 2 we cover the risks involved with using the product and how to get started.

How does HL work?

The main vault i.e. HLP on the Hyper Liquid market operates via an orderbook, which is protocols vault that provides liquidity. Users have the ability to create their own vaults to execute their strategies and attract liquidity to their vault.

It is important to note that it may not always function as the counterparty for all participants, depending on the liquidity dynamics within the platform.

The HyperLiquid L1 state encompasses all margin and matching engine states. It is worth noting that Hyperliquid does not depend on off-chain order books. A fundamental design principle is complete decentralization, achieved through Tendermint consensus, which ensures a consistent order of transactions and is optimized for end-to-end latency. HLP vault is the in house market maker vault for platform, helping build strong orderbook.

For an order placed from a geographically co-located client, end-to-end latency has a median 0.2 seconds and 99th percentile 0.9 seconds.

The validators are responsible for publishing spot oracle prices for each asset every 3 seconds. The oracle prices are used to compute funding rates. They are also a component in the mark price which is used for margining, liquidations, and triggering TP/SL orders.

The spot oracle prices are computed by each validator as the weighted median of Binance, OKX, Kraken, and Huobi spot prices for each asset, with weights 3, 2, 2, 1 respectively. Oracle price is used for computation of funding rate & mark price.

Mark price= Oracle price + 5 minute EMA of difference between -(Hyperliquid's mid price and the oracle price). This means for accurate mark pricing it must have robust orderbook. This is particularly useful during periods of high volatility when oracle prices begin to lag and result in significant liquidations.

DYDX uses oracle prices for liquidations and TP/SL which tend to lag in the periods of high volatility.

Risks

• Infrastructure risks-
  As much as it is luring to airdrop farm in size here or trade all your shekels on HL, its prudent to list down and understand all the risks associated with their setup currently.
  *-> Bridge risk *
  currently it’s a closed source bridge with no public 3rd party audit. But upon a long discussion with the team over ☕️ at Token2049 they ensured us they will be soon publishing 3rd party audits and making the source code public. Plus will some [redacted] magic have more security and decentralization. 😉 Thats great news… and makes us hopeful this project helps accommodate size.
  -> Validator risks
  as of today the HL product is quite centralized with 4 nodes and all of them run by the core team. Since HL uses tendermint consensus which can easily scale up to 100 validator nodes (like Polygon PoS) or become a validium (using Polygon CDK) where you don’t have to worry about security bcoz its Ethereum dawg !! I am sure the team (they confirmed) is building actively to decentralize over time with incentivized testnets and more.
  -> HLP risks - There is smart contract risk relating to HLP pool. Other being HLP strategy losing in trending markets. Although all the trades & TVL can be easily verified on-chain.
  → FTX-Alameda risk - Some users speculate that HLP may be able to frontrun the user trades. However since all trades are publicly available on-chain, one can validate they are not doing so. While we haven’t done this so far, we invite the community to run tests here.

Platform Risk-
Hyperliquid has some “special” features that are positive for solvency for HLP and Hyperliquid.

• If Auto deleverage is triggered then traders with negative margin will be settled against most profitable trader. In simpler terms, if it comes down to solvency for platform bad debts will be settled from most profitable traders with leverage.
  
  Below is a conversation with the founders that sheds light on this crucial aspect:

"If Auto deleverage is triggered then traders with negative margin will be settled against the most profitable trader. In simpler terms, if it comes down to solvency for the platform, bad debts will be settled from the most profitable traders with leverage."

     When asked to clarify this process, the founders provided the following response:

"Yes, that is correct. When ADL happens, the bad debt is passed onto profitable traders on the other side. This is how ADL works on CEXs too, and it's a last resort measure that has never yet triggered on HyperLiquid."

• In case of liquidation maintenance margin is not returned which is very high for volatile coins. So keep SL to protect against liquidations and preserve maintenance margin.

Summary

All in all we love the product and have been actively trading on it for the past few months. We felt it’s our responsibility to outline the risks involved and thus a part 2 was necessary.
Good for scalping, not yet safe to move size in.

Disclosure - click here to learn more about 3poch’s Hyperliquid disclosure.