Continuing the discussion from Tier 4 Fund Management Discussion:
The “Tier 4 Fund Management Discussion” would greatly benefit from an overview of the all liquidity tiers and an understanding how they interact with each other.
The “Finalized evolution of liquidity operations” defined the different tiers, but lacks the feedback loops between the different tiers.
The category “NuShares” might not be ideal, but I haven’t found a better one.
TL;DR
The current Nu liquidity operation still is rather based on gut feeling than on facts and thresholds. The sooner this gets changed, the earlier Nu can start to adjust the parameters based on experience.
Here’s a summary of the current liquidity model including an assessment/interpretation.
Funds get moved between tiers. Nu either does that or incentivizes it to happen.
Depending on the interface the friction is bigger or smaller, lead time is longer or shorter.
Thresholds that trigger action should be defined to make liquidity providing more reliable and to enable Nu with metrics.
A text wall will follow, but as there’s a lot of work to do in terms of developing fund handling on different tiers I went into greater detail.
The intention of this post is not to provide a complete solution; it’s rather trying to get the ball rolling.
Please join the discussion to define or refine the understanding of liquidity!
Summary and interpretation of the tiers
Tier 1
This liquidity is immediately available, being on the order book. Basically, the level of liquidity in a particular market should be matched but not exceeded by NuBot (annotation: and PyBot for ALP).
Interpretation:
Tier 1 is outside direct control of Nu. Nu controls tier 1 indirectly by providing incentives to put orders on sell and buy side.
That was once different when @KTm and @jmiller provided liquidity with funds that were owned by Nu, but has changed with the transition to the decentralized liquidity operation model.
Tier 2
This liquidity sits on exchanges but is not placed on order books and can be promoted to the order book (Tier 1) in a couple seconds. When Tier 1 liquidity is consumed and it can be verified that the corresponding trade in the real market has been successfully executed, NuBot promotes funds in Tier 2 to Tier 1 by placing orders.
Interpretation:
Tier 2 is outside direct control of Nu. Nu controls tier 2 and the promotion to tier 1 indirectly by providing incentives to put orders on sell and buy side. A shift of funds from tier 2 to tier 1 is incentivized with the compensation for tier 1 funds that is provided by Nu.
If Nu wants to have funds moved from tier 2 to tier 1 an increase of the compensation for tier 1 is the key.
Tier 3
This liquidity sits off exchange and is held by liquidity providers in wallets not exposed to counterparty risk or the risk of NuBot malfunction. It can be promoted to tier 2 when needed in minutes.
Interpretation:
Tier 3 is outside direct control of Nu. Nu controls tier 3 and the promotion to tier 2 indirectly by providing incentives to put orders on sell and buy side (which ultimately will move the funds from tier 3 to tier 1). A shift from tier 3 to tier 1 (via tier 2) is incentivized with the compensation for tier 1 provided by Nu. If compensation is provided for tier 2, Nu can incentivize moving funds from tier 3 to tier 2.
Remark:
Promoting tier 3 to tier 2 might take much longer than a few minutes. Depending on how long the confirmations take and how many confirmations are required by an exchange, it might take significantly longer than minutes.
Tier 4
This liquidity can be provided by custodians not dedicated to liquidity operations. A present example are the proceeds of NuShare sales. They are intended for operational and development expenses, but can be used to support the critical function of liquidity provision as needed. When these funds are used for liquidity, they are exchanged from one type of asset to another, but are still available for their original purpose, such as development. These funds can be promoted to tier 3 in hours and the cost is exchange rate risk.
Interpretation:
Tier 4 is in full control of Nu. Funds in tier 4 belong to Nu, are owned by Nu. Tier 4 is meant to be used for “operational and development expenses, but can be used to support the critical function of liquidity provision as needed”.
It might be helpful to distinguish between “colors” of tier 4 funds. In the end it might make things more complicated for little gain. Accounting wise it would be helpful to have separate instances of tier 4. In the end all is money that is owned by Nu and that gets managed for a purpose (or for purposes).
Development and operational expenses sometimes might be required to be paid in BTC. In fact a lot of development was paid with NBT and Nu doesn’t know how much of the NBT ended in the buy walls (which effectively made Nu pay with BTC).
Anyway, in case the funds on tier 4 buy side were depleted, BTC need to be obtained by selling NSR - no matter for what reason.
In the end it doesn’t matter whether tier 4 needs to be refilled because of development or because of keeping the peg.
Filling tier 4 is done by NSR holders vote. It needs to happen from a higher Tier.
Tier 5
This liquidity presents itself in a decentralized manner from the manipulation of interest rates (park rates). This liquidity is generally buy side, although technically it can be sell side in the case of lowering interest rates. This liquidity is available in days and the cost takes the form of interest paid.
Interpretation:
Tier 5 is in full control of Nu. Parking rates are adjusted by NSR holder vote.
Tier 5 is not a Tier like all others as it creates an inseparable, but time shifted effect on the buy and the sell side. Raised parking rates lower the sell side (increasing the ratio between buy and sell), because more NBT get parked. Later, when the NBT unpark, more NBT than were parked (and removed from the sell side) enter the market and might enter the sell side. The degree depends on the situation at the point of time the NBT unpark.
Tier 6
This liquidity takes the form of custodial grants for sell side and currency burning for buy side (presuming a currency burning motion is passed and implemented as appears likely). It takes a week or more to bring to market but has zero maintenance costs.
Interpretation:
Tier 6 creates NSR to have them sold for BTC to support the buy side or creates NBT to support the sell side. Creation of one or the other is necessary if the buffering capabilities of the lower tiers run dry. Tier 6 should create NBT or NSR and transfer them to tier 4 to (re)fill tier 4 funds or utilize tier 4 to bring them to market.
If NBT or NSR buybacks (to burn the retrieved asset) is intended, seeded auctions can be used to bypass tier 4.
Nu, the LPs and the tiers
The summary makes quite clear, that the lower tiers 1 to 3 are outside of direct control by Nu.
The funds in these tiers don’t belong to Nu (under normal circumstances). A special case is in the times NSR,BTC or NBT enter the market from a higher tier to get exchanged.
The tiers 4 to 6 are under direct control by Nu.
Tier 5 is a special case, because the NBT that get parked don’t belong to Nu. They are destroyed and created by protocol during parking and unparking. One could argue that the parked NBT create a temporal liability for Nu, Nu borrows NBT from the market to adjust the sell side, paying a compensation for that.
Waterfall effect
Adjusting volume on tier 1 by providing incentives to do so, siphons funds from higher layers. Increasing compensation for tier 1 will move money from tier 2 to tier 1. If the incentive is big enough and tier 2 is reduced, tier 3 funds will be moved from tier 3 to tier 2.
The thresholds for those movements are set by liquidity providers and can’t be adjusted by Nu.
All Nu can do to interfere with the waterfall effect on the levels 3 to 1 is providing an incentive to put money on tier 1 (and maybe tier 2).
Beginning on tier 4 it’s different. Nu does have the funds under direct control and depending on the market and liquidity situation funds from tier 4 can be injected into the market. The injection can happen on different tiers. The bigger the urgency the lower the tier which funds from tier 4 will interact with.
Slowest action would be to interact with tier 3; tier 2 would be faster; tier 1 has an immediate effect.
To be able to support both the buy and the sell side, tier 4 funds need to hold BTC (maybe a part in NSR to reduce the dependency from BTC) and NBT.
Whether the fund management of the different side is in different hands is something that needs to be defined as well as the amount of funds that shall be in tier 4 (in relation to the sum of funds in tier 1 to 3?) and the thresholds (and the velocity of the change?) that trigger action.
Metrics, triggers, actions
Tier 4, (5) or 6 involvement is required if tier 1, 2, 3 reach certain absolute values or ratios. As long as there are hundreds of thousands of NBT in the wild, absolute values are less important than ratios of buy and sell side.
If funds are running low in tier 1-3, they need to be refilled from tier 4-6.
Tier 4
The buy and sell side might have different thresholds to trigger action. Initially the same thresholds should be fine. That can be adjusted in following iterations.
Example:
tier 4 funds get activated if one side (sum of tier 1 to tier 3) has double the volume than the other. The balancing shall bring the sides in equilibrium.
As long as no side is at least double the other, nothing happens.
Please note that this is only an example; other examples will follow.
Remark:
The velocity of ratio change of buy and sell side could be included in the triggered action, but would make things more complicated. I’d rather consider that a next iteration step.
Tier 5
I have no clue how to intelligently include Tier 5.
As adjusting parking rates have a delayed effect on the liquidity, because it takes time until they are adjusted, I consider a continuous and early adjustment of parking interest more effective than adjusting the parking rates in case of emergency.
Example:
if the (average sum of tier 1 to tier 3 in the last time frame x) sell side liquidity is bigger than buy side, NSR holders are expected to raise parking interest above 0%.
And this is where I start getting clueless. How high to raise the parking rates depending on which circumstances?
Remark:
tier 5 can be used to reduce the sell side, increasing the ratio between buy and sell side. It can’t be used to increase buy side, obviously.
Tier 6
Assuming tier 6 is being used to fill/increase funds, it needs to be activated based on tier 4 status.
For the start it might be ok to have the same rules for both sides. As NBT on tier 4 sell side pose neither volatility nor default risk for Nu, they can be treated completely differently (q.v. FSRT).
Especially for the buy side it might be helpful to keep a ratio between funds on tier 4 and NBT in the wild, e.g. approximately 12% of NBT value need to be held in tier 4 buy side.
A corridor for the rate saves from frequent action.
Example:
the tier 4 buy side shall be kept on 12% with a corridor of +/- 3 percent points.
Once tier 4 buy side is below 9% NBT value in the wild (or a percentage of the sum of tier 1 to 3?), tier 4 buy side gets filled with funds from tier 6.
It’s strictly recommended to let a custodian grant pass for creating NSR, which will be exchanged for BTC to fill tier 4 buy side.
Once tier 4 buy side is above 15% of NBT value in the wild (or a percentage of the sum of tier 1 to 3?), tier 4 buy side moves funds to tier 6. BTC are handed over to tier 6 fund managers, who will exchange them to NSR and burn them; a shortcut is to have tier 4 managers obtain the NSR and burm them.
Remark:
using absolute values of NBT in the wild rather than the value of tier 1 to 3 makes it harder to game the system and should be preferred.
Conclusion
I know that this is a lot of stuff. Honestly I couldn’t have made a less elaborated version to make this vision clear.
I’m aware that there will be a lot of discussion, because interpretations will differ. I hope that in the end Nu will be closer to a “management framework” for dealing with funds.
The first draft won’t be perfect, but everything might be better than doing all based on gut feelings.
