Understanding LYDRA — Key Concepts and Dynamics
Last updated
Last updated
Recently we had the pleasure to announce the much anticipated LYDRA launch event, which is scheduled for December 12th! We are as excited as you and can’t wait to see how the community will use the new feature.
In the meantime we want to share a summary article that recaps the most important things you need to know about LYDRA. We recommend to read through this material before engaging with the mechanism.
LYDRA stands for “Liquid HYDRA” and is a protocol-issued derivative of the HYDRA coin. The main purpose of it is to allow you to maintain liquidity while continuing to stake your HYDRA passively.
In short, you can stake your HYDRA and enjoy passive income, all while using your newly minted LYDRA to engage in other activities. This is completely optional though. You can also stake HYDRA without using LYDRA at all.
The contract address of the LYDRA token is:
You can mint LYDRA tokens by locking up the same amount of HYDRA, which can continue to stake and earn you passive income (possible for both self-staking as well as delegation). You will always receive a 1:1 ratio relative to the amount you locked up. For example, if you lockup 1,000 HYDRA then you can mint a maximum of 1,000 LYDRA.
Note: There is a small buffer amount that the protocol will prevent from being locked, in order to ensure you have sufficient freely movable HYDRA to pay for the fees of several transactions.
After minting your LYDRA, you can freely move them out of your wallet and do with them whatever you want (more on that in section 4). Notice that your HYDRA will now be locked inside the wallet and can not be moved out. They can however continue to stake.
Interface Options to Mint LYDRA:
Note: Minting/burning LYDRA via the Hydra DEX and Mobile Wallet is now available! However consider that the minting will consolidate your UTXOs. Therefore we recommend to use the staking client for self-staking or delegated wallets. Since there you can optimize your UTXOs easily.
If you want to unlock your HYDRA, you will need the same amount of LYDRA back in your wallet. For example, to unlock 1,000 HYDRA you will need to burn 1,000 LYDRA.
→ The protocol always adheres to the fixed ratio of 1:1 in both directions.
Although the protocol treats HYDRA and LYDRA as equals, the actual value of LYDRA on the free market will be lower than the one of HYDRA. This is because there is a financial incentive to sell LYDRA if its price is equal or higher than the one of HYDRA (more on that in section 5).
For now it is important to understand that there are two different rates for LYDRA:
Protocol Level Rate → Fixed 1:1 ratio for minting/burning LYDRA
Open Market Rate → Dynamic market rate with LYDRA being traded at a discount to HYDRA
The open market rate will be fluid at all times and may depend on many factors. One of its main drivers will be the opportunity to engage in leveraged staking.
Leveraged staking is a powerful concept that becomes possible thanks to the LYDRA mechanism. The goal hereby is to boost the staking APR by increasing the amount of HYDRA staked. Below is one example, which is based on the assumptions of a network-wide staking APR of 35% and a free-market LYDRA/HYDRA price ratio of 0.6 (meaning that 1 LYDRA = 0.6 HYDRA).
Step 1: Stake 1,000 HYDRA Step 2: Mint 1,000 LYDRA Step 3: Trade 1,000 LYDRA for 600 HYDRA Step 4: Stake 600 HYDRA
As a result, the user now has 1,600 HYDRA staked as opposed to the initial 1,000 HYDRA. Therefore, this acts as a 1.6x leverage on the staking income. When measured against the principal amount of 1,000 HYDRA this translates to an effective APR of 35% * 1.6 = 56%.
This form of leverage is not subject to liquidation risk, because the asset that is used to achieve the leverage is a direct derivative of the asset that is being leveraged. Since LYDRA is backed by HYDRA, they correlate with each other in price.
The ability to enjoy leveraged staking income without having to worry about liquidation price levels is a unique advantage of the LYDRA mechanism.
At this point it is important to emphasize that it is still possible to experience financial loss, however not in the form of liquidations (margin calls). As a result, unrealized losses due to price exposure can be reversed if the price ratio moves back into more favorable levels — something that is not possible with systems that involve liquidations, as those enforce the losses to be realized.
More importantly, while waiting for more favorable prices, the staking income keeps accruing — gradually offsetting ratio-related losses over time (or adding to a potential profit).
The position is essentially de-leveraging itself over time, as the LYDRA debt remains constant but the HYDRA balance keeps growing as a result of staking income.
→ Therefore the debt-to-asset ratio comes down naturally.
We will now discuss the risks arising from price ratio exposure, based on the previous scenario of the leveraged position.
Let’s imagine that after some time the user decides to unwind the leverage and that the market ratio moved from the initial 0.6 during the opening of the position to 0.8 at the moment of closing it. Remember that this is the previous situation snapshot:
1,600 HYDRA staked
1,000 LYDRA debt to the protocol (due to previously locked 1,000 HYDRA)
To unwind the leverage and exit the position, the user will need to buy back the previously sold 1,000 LYDRA. However, since now the market rate has risen to 0.8, it will cost a total of 800 HYDRA to buy them back. Which means that the end result will be a 800 HYDRA balance (translating to a 200 HYDRA loss relative to the starting point).
Note: The trade may still be profitable, if the boosted staking income during the leveraged period was able to compensate or even surpass the loss from the price exposure.
4.3 Composition of Profit/Loss
As mentioned above, it is important to realize that the leveraged staking strategy has two components to it:
Increased staking income (always positive)
Exposure to price ratio (positive or negative)
At the end what matters is the combination of the two. The benefit of the increased staking income will primarily depend on:
Network APR
Duration of the position
The more favorable these two are, the higher the benefit of the leveraged position.
4.4 Example #2
In the first example we assumed a negative scenario for the price exposure component. However, it is also possible that the ratio develops favorably. Let’s assume that this time the ratio drops from 0.6 to 0.4. Considering the same starting scenario:
1,600 HYDRA position
1,000 LYDRA debt to the protocol
At a ratio of 1 LYDRA = 0.4 HYDRA it would only cost 400 HYDRA to buy back the required LYDRA. As a result, the user would end up with 1,200 HYDRA net balance, which is a 200 HYDRA profit. This of course is again further reinforced by the boosted staking income that was enjoyed throughout the position period.
4.5 Summary of Profit/Loss Conditions
Boosted staking income is always positive → Ideal Scenario: High network APR + long position duration
Price ratio exposure can be either positive or negative → Ideal Scenario: Opening position during a high ratio + closing position during a low ratio
4.6 Multi-Loop Strategy
Since LYDRA is designed in a modular way, it is possible to repeat the process though several loops.
Stake HYDRA → Mint LYDRA → Swap for HYDRA → Repeat
The only limiting factor is the price ratio that is always below 1, which results in diminishing returns with each cycle. Below is an example for the effective APR at 0.6 price ratio:
Default → 35% APR Loop 1 → 56% APR Loop 2 → 69% APR Loop 3 → 76% APR Loop 4 → 81% APR Loop 5 → 83% APR
Notice how the additional benefit slows down with each additional loop.
4.7 De-Facto Liquidation
The multi-loop strategy can result in a de-facto liquidation, in the form of a near-total loss. There is still no margin-call and no forced closure of the position, but higher leverage through more loops means that the potential loss is also amplified due to higher exposure to the price ratio. → This of course works in both directions, generating a higher profit in the event of a favorable price ratio movement.
Since the price ratio can never exceed 1:1, there is a ceiling for the worst possible loss that can arise from price ratio exposure, which can be calculated. Assuming the same 0.6 price ratio at entry and the worst possible price ratio of 1:1 at exit, we arrive at:
Loop 1 → max loss of 40% Loop 2 → max loss of 64% Loop 3 → max loss of 78% Loop 4 → max loss of 87% Loop 5 → max loss of 92%
This of course is hypothetical, because it is very unlikely for the 1:1 ratio to ever materialize (as explained in section 5), but should still be considered as a distant possibility.
4.8 The Flip-Side
Since the price ratio can move both ways, the maximum potential profit can be calculated similarly, by assuming a theoretical price ratio of 0 on exit (with same 0.6 assumption on entry):
Loop 1 → max profit of 60% Loop 2 → max profit of 96% Loop 3 → max profit of 117% Loop 4 → max profit of 130% Loop 5 → max profit of 138%
A price ratio of 0 is equally hypothetical as it would indicate something fundamentally wrong with the mechanism.
4.9 Importance of the Entry Ratio
Both of the calculations were based on the assumption of a price ratio of 0.6 during entry. The actual ratio will of course depend on the market rate. Below are some simulations for various price ratios, assuming just a single loop:
Adding more loops to the equation will amplify these results, although the loss can never exceed 100%.
The table above shows clearly that higher price ratios are less risky as an entry point. This also explains why the ratio is never expected to go above 1:1, since at that point the risk-reward would be fully on the profit side.
But why is this? How can we be sure that the price ratio won’t sustain itself above 1:1? There are two main reasons for this:
1) Arbitrage Mechanism → If the price ratio was to exceed 1:1 by reaching for example 1.05, then this would present an instant arbitrage opportunity:
Step 1: Buy 1,000 HYDRA Step 2: Mint 1,000 LYDRA Step 3: Swap for 1,050 HYDRA = 50 HYDRA free income
Hence we know that a ratio above 1 can not be sustained for long. But how about a ratio of exactly 1?
2) Infinite Leverage Opportunity → If the price ratio was exactly 1:1, it would open up an opportunity for infinite leverage:
Step 1: Stake 1,000 HYDRA Step 2: Mint 1,000 LYDRA Step 3: Swap for 1,000 HYDRA Step 4: Repeat = Infinite (!) Staking APR
Since in this hypothetical scenario there is no efficiency loss between loops, it would allow for risk-free and infinite leverage. Anyone who wants to take advantage of this will inevitably drive down the price ratio as part of step 3 of every cycle.
The theoretical lower limit of the price ratio is 0, as with every asset. But given that LYDRA is backed to 100% by HYDRA as collateral, it is unlikely for very low ratios to be maintained either. As those who staked HYDRA will need to buy back LYDRA at some point to unlock their funds.
Therefore we can conclude that the expected range of the price ratio is between 0 and 1, with the edges of the range being corner cases with a high imbalance between risk and reward — hence not expected to be sustained for long.
All of this is great, but what happens if you lose all or part of your LYDRA tokens? This can happen either via financial loss (bad trades) or technical loss (sent to wrong wallet address etc).
One thing to always remember is that you need your LYDRA to unlock your HYDRA. Without them, your HYDRA will remain locked forever. Although they can keep generating staking income (which will not be locked), the principal itself will not be redeemable.
The good thing is that even if you no longer have LYDRA, it is always expected to be profitable to buy new LYDRA from the markets for the purpose of unlocking your HYDRA.
Why? Because remember that LYDRA will trade at a discount relative to HYDRA. So even in the scenario where you don’t have sufficient LYDRA, the isolated act of unlocking your HYDRA (with newly bought LYDRA) is expected to be profitable. You would buy LYDRA at a discount to unlock HYDRA at full price.
There is of course a lot more that can be touched on, but with these basics you should have a sufficiently good understanding of the inner workings of the LYDRA mechanism. Make sure to always consider your own risk tolerance before proceeding with your strategy.
