Managing Contagion Risk

The Contagion Risk Question

"If I can use all my positions as collateral for other positions, does this not increase the risk that one highly leveraged user causes many other users to get liquidated, or that there are now many dependencies making WCM more fragile? This sounds too good to be true."

It is important to delineate between perceived risks actual risks using WCM.

Perceived Risks

• The perception of one highly leveraged user wiping out many other users is a perceived risk, not an actual risk.

• The perception that netting market exposures increases risk, or that enabling more leverage from netting increases risks, are both perceived risks, not actual risks.

• The perception that one user can lend to another, who can lend to another, and so on, causes a kind of cascade risk, is also a perceived risk, not an actual risk.

• The perception that the protocol can end up "holding" low quality assets, is a perceived risk, not an actual risk as the protocol does not hold positions.

Actual Risk

The question to ask is, "Are there scenarios in which the liquidation engine cannot recover enough USD to pay back all creditors, i.e. pay back all counterparties to the loans and perp positions in the portfolio?" These scenarios, and only these scenarios, have contagion risk.

Other Exchanges Manage with ADLs

Most perps exchanges "manage" this problem with ADLs. The exchange or associated operator takes over your positions, whether they are making or losing money, and closes them out. On centralized exchanges, this mechanism, typically called the "Insurance Fund" translates to a kind of internal trading desk which trades against you, and without any reporting or transparency, under the guise of "risk management." One would expect full transparency if these exchanges had nothing to hide, as it would benefit users, who would in turn trust the exchange more, benefiting the exchange. You can read more about WCM's liquidation process in Liquidation & No ADLs.

WCM has No ADLs

WCM has no ADLs.

WCM Manages with Onchain Risk Parameters

Instead, the problem is managed with fully onchain, verifiable, per-asset risk parameters. Because the future is not knowable, there is no perfect solution, but we believe this is the best solution.

The scenario in which the liquidation engine cannot recover enough USD is specifically, the scenario in which the risk parameters do not capture the materialized volatility and local liquidity of an asset listed on WCM. These risk parameters are responsible for managing contagion risk on WCM.

Contagion Risk Management

WCM sets 2 risk parameters for every asset:

1. Risk Price, a volatility parameter, and

2. Risk Slippage, a local liquidity and spreads parameter.

These parameters are then added together and entered into the margin calculation, as described in Risk Based Portfolio Valuation.

If the sum of the above two risk parameters do not fully account for the materialized volatility and available local liquidity (available, over some duration) of an asset, for example, during a sharp market sell off where all the liquidity moves to the other side of the book, the liquidation engine will not be able to recover enough USD during the liquidation process. Consequently, the users holding this asset will be unable to fully pay their creditors, which will reduce the NAVs and subsequently the available margins of these creditors. If leveraged positions of this asset are widely held on WCM, it introduces contagion risk beyond the holders of these positions. This is the real risk - specifically, the sum of the risk parameters should ensure there are no scenarios in which the liquidation engine cannot reclaim enough USD (or equivalent) to repay all creditors for positions of a given asset.

A subtle, but powerful property of WCM is that all risk settings are fully onchain and transparent. One can find them in the Stats section of the application. The below screenshot is of the test application, the values are not real. All users, at all times, can see the risk parameters and deterministically know all inputs and calculations with respect to possible leverage and possible risk taking on the exchange, for all users of the exchange. There is perfect verifiable and unprecedented information symmetry between WCM and all of its users, uniquely solving the agency problem (i.e. conflict of interest with the exchange) described in Actual Risk above.

Needless to say, these parameters are set with the research and intention of never approaching scenarios which could introduce contagion risk.

We believe perfect information symmetry of the risk parameters of WCM will naturally evolve these parameters to an efficient market outcome, which maximally benefits its users. At the margin, one would expect to see additional capital arrive on WCM with incrementally better parameters, and conversely capital leave with incrementally worse parameters, iteratively working towards the settings which attract the most capital.

Moreover, every user has perfect insight into the portfolios of their counterparties at all times. Traders are then able to navigate counterparty risk dynamically, eliminating the need for "ADLs" near ubiquitous in other perps markets. Read Liquidation & No ADLs to learn more.

Circuit breakers and multiple price sources protect traders from 10/10-like scenarios.