Protecting Users from Bad Debt
November 21st, 2024

Introduction

Just like any other trading protocol, user safety and risk mitigation is critical to the success of Variational. The Variational protocol employs a peer-to-peer (P2P) model with segregated settlement pools, which differ significantly from traditional exchanges that pool all user funds. The decision to use individual settlement pools for each user was deliberate, and offers unique advantages in minimizing bad debt and protecting users from counterparty risks.

What is Bad Debt?

Bad debt arises when a trader incurs losses and cannot fulfill their financial obligations to their counterparty. This typically occurs when the market moves rapidly against a trader's position, leaving them with a negative balance before the liquidation engine can liquidate their position(s).

In traditional exchanges, bad debt is often socialized, meaning losses can be spread across all users or covered by an exchange insurance fund. The Variational protocol takes a different approach, with a P2P model that gives each trader an individualized settlement pool. This segregation helps prevent losses from cascading through the system, as bad debt can be isolated to specific pools.

How Does Variational Protect Users From Bad Debt?

Variational's unique P2P architecture helps protect both the platform and users from bad debt with segregated settlement pools, the ability to select specific counterparties, and a highly efficient margin and liquidation engine.

First, each P2P trade is conducted within its own isolated settlement pool. When a user opens a position with a new counterparty (on Omni, this counterparty is always OLP), a new settlement pool is created to custody the margin required from both parties. On Pro, whenever a maker creates a new pool, they can choose to either isolate each counterparty to a unique pool, or bundle all takers into one settlement pool. Takers on Pro are then able to view each maker’s pool settings before accepting or rejecting any quotes. This model ensures that losses/bad debt in one pool does not impact others. This compartmentalization prevents contagion and protects users from systemic risks.

Trades on Variational also have clearly defined counterparties. On Omni, the counterparty is always OLP. On Pro, users can select their counterparty and research them before entering a trade. This transparency allows users to assess the counterparty risk associated with each trade and make informed decisions.

Finally, Variational also introduces a robust margin and liquidation engine that requires traders to maintain sufficient collateral to cover potential losses. If a trader's position becomes undercollateralized, their position is automatically liquidated, preventing further losses and minimizing the risk of bad debt. Lots of development effort has been spent optimizing the liquidation engine, as even small delays in liquidations can result in the accumulation of bad debt.

While we've made significant effort to minimize bad debt within the Variational protocol, it's important to acknowledge that counterparty risk still exists. If a counterparty's balance goes negative due to volatility that occurs too fast for the liquidation engine to act before bad debt is accumulated, there's no mechanism to force them to cover the losses. This is an inherent risk in any P2P system.

Conclusion

By segregating settlement pools, allowing for transparent counterparty identification, and the creation of a robust liquidation engine, Variational is protected against widespread contagion. However, users should always understand the inherent risks of P2P trading and, when using Pro, choose counterparties responsibly.

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