Economic Risk
The fundamental financial concerns are Solvency Risk and Liquidity Risk. Hummus Exchange ensures its financial health by monitoring and applying strategies to mitigate these two risks.
Solvency Risk
We define liquidity provision as liability, Li; and the amount of token i held by the protocol (both cash and account receivable) as asset, Ai for token i account. The coverage ratio ri is defined to be Ai, which is a measure of solvency risk of token i account. The higher the Li coverage ratio, the lower the solvency risk.
We further divide solvency risk into account-level and system-level:
Temporary insolvency does not imply permanent insolvency. For account-level insolvency, the solvency position may be restored when users perform token swapping from the insolvent token to other tokens. For system-level insolvency, the solvency position may be restored when the future income of the system is sufficient to recover any shortfalls that exist or if additional equity is injected into the system.
Liquidity Risk
We define the amount of a liquid token i held by the protocol as cash, Qi for token i account. The quick ratio is defined to be Qi, which is a measure of liquidity risk of token i account Li.
The higher the quick ratio, the lower the liquidity risk. When Qi ≥ 1, the protocol is fully liquid; therefore, all liability can be settled by cash held in the protocol. The quick ratio needs to be maintained above a certain level to avoid illiquidity (i.e., default) of the protocol.
If all liabilities are immediately redeemable, insolvency of a token may directly entail the possibility for illiquidity of the token. However, it is reasonably safe to assume that not all capital will be withdrawn at once given that the long term confidence of the protocol is intact (this is also an assumption of modern banking’s fractional reserve system.)
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