Vest Liquidity Pool

The Vest Liquidity Pool acts as the primary counterparty to trades on the platform and is essential to the system’s risk management architecture. Liquidity providers (LPs) commit aggregate capital $L$, which, alongside AMM-owned capital, $P$, serves as a buffer against trader profit and loss (PnL).

We now provide a calculation of yield sources. LPs are compensated via:

1. Risk premia

A premium is charged or rebated for each new trade, depending on how it changes the overall risk of the system. A portion of this is allocated to LPs. The LP premium is structured as a call spread on a virtual asset, with the premium given by:

$\pi_t^L = \left( C_{K_1(\theta'), K_2(\theta')}(t, t+\tau) - C_{K_1(\theta), K_2(\theta)}(t, t+\tau) \right)^+$

Where $K_1(\theta) = C + P$ and $K_2(\theta) = C + P + L$ are the strikes representing capital levels before and after the trade.

1. Funding payments

LPs also receive ongoing funding fees from open positions. These are derived from the sensitivity of the risk-adjusted spread value to time, distributed proportionally across markets using Euler allocation:

$f_t^L = \frac{\partial C_{K_1, K_2}(t, t+\tau)}{\partial \tau}$

Note: Vest uses a buffer system to stabilize returns and reduce volatility. This buffer increases with realized trader losses and a portion of collected fees. It is the first layer used to offset negative trader PnL before touching LP capital. By reducing the variance in LP returns, the buffer enhances the Sharpe ratio and makes capital provision more attractive.

The LPs’ exposure can be modeled as a short call spread, with bounded downside. Their net payoff is given by

$Y_t = -\left(S_t^v - (\bar{s}^v + P)\right)^+ + \left(S_t^v - (\bar{s}^v + P + L)\right)^+$

Here, $S_t^v$ is the price of a virtual asset representing the exchange’s inventory and $\bar{s}^v$ is the average entry price of the AMM. The bounded payoff ensures LP losses are capped and confined to well-defined tail scenarios.