P2P Trading Protocol vs DEX

Variational is not an exchange; it is a peer-to-peer trading protocol. Although the user experience feels very similar to an exchange when using apps like Omni, the decision to build Variational as a protocol and not an exchange was very deliberate, and comes with certain tradeoffs.

Segregated Risk Pools vs. Commingled Risk

An exchange works by mixing all user funds in one bucket, and then doing careful accounting to determine each user's balance and positions. Variational works by having completely segregated settlement pools, which are on-chain smart contracts with funds isolated from other settlement pools.

All positions in a settlement pool are peer-to-peer, meaning you have an explicit counterparty who is taking the other side of the trade. For example, all trades between Alice <> Bob may be in one settlement pool, and all trades between Cheryl <> Douglas in another.

All users trading on Omni have their own settlement pools defined as User <> Omni Liquidity Provider (OLP).

	Peer to peer model	Exchange model
User funds	Isolated and segregated into settlement pools	Commingled into one pool
Liquidity discovery	Request-for-quote	Central limit orderbook (CLOB)
Counterparty	Explicit counterparty who is on other side of trade	Anonymous counterparty on the orderbooks

In a peer to peer model, one settlement pool going bankrupt has no effect on healthy settlement pools; there is no contagion. Healthy settlement pools remain solvent and pay out as expected for uninvolved users. This is in contrast to an exchange model, in which any loss of funds may be socialized across all users of the platform, regardless of whether they were at fault or not.

On the other hand, the health of the counterparty is much more important in a peer to peer model. In an exchange model, if your counterparty has a negative balance, you are still guaranteed payout as long as the exchange is solvent. There is no such backstop in a peer to peer model. The funds deposited into the pool are the only funds available. This is explained further below.

Counterparty Risk and Bad Debt

The basic principle for the peer-to-peer model is that whatever collateral that is deposited into the settlement pool is the only collateral available backing the trades. The margin engine will require both counterparties to maintain certain collateral levels, or else positions will be liquidated.

In certain rare cases, the market may move so quickly that a counterparty's balance goes negative. There is no way to force the bankrupt counterparty to deposit more collateral to cover the losses. We refer to this situation as bad debt, where there is no way for the winning counterparty to realize his profits, i.e. collect the debt from the bankrupt counterparty.

This is an inherent risk of trading in a peer to peer system. Please make sure you understand the margin requirements and liquidation system before entering into any trades.