> For the complete documentation index, see [llms.txt](https://docs.firelight.finance/llms.txt). Markdown versions of documentation pages are available by appending `.md` to page URLs; this page is available as [Markdown](https://docs.firelight.finance/risk-and-pricing-model/capital-adequacy.md). # Capital Adequacy Capital adequacy is the portfolio-level discipline that keeps Firelight solvent across all the coverage it writes. This page describes the full framework: available capital, effective leverage, the Solvency Capital Requirement, and the Capital Adequacy Ratio that ties them together. ### The capital adequacy equation The central metric is the Capital Adequacy Ratio: `CAR = Available Capital ÷ Solvency Capital Requirement` | Term | Definition | | ---------------------------- | ---------------------------------------------------------------- | | Available Capital | First-loss buffer (in USD) + market value of staked assets | | Solvency Capital Requirement | The capital the protocol must hold against its in-force coverage | A higher CAR means more capital backing each dollar of coverage. Firelight targets CAR between 1.5 and 2.0 in steady state, and between 1.75 and 2.0 at the feature-complete launch. The Solvency Capital Requirement reflects two things: a coverage-over-leverage component (driven by how much coverage is in force and the protocol's effective leverage) and a portfolio expected-loss component drawn from the live economic and technical views of every covered market. The portfolio-EL term is what makes capital adequacy responsive to the actual monitored risk of the book, not just its size. ### CAR bands and actions Every portfolio state falls into one of five bands: | CAR level | Status | Action | | ------------ | -------- | ----------------------------------------------------------- | | 2.0 or above | Strong | Normal operations. Capacity available for growth | | 1.5 to 1.99 | Adequate | Normal operations. Maintain monitoring | | 1.2 to 1.49 | Watch | Enhanced monitoring. Restrict new coverage | | 1.0 to 1.19 | Warning | Suspend new coverage except renewals. | | Below 1.0 | Critical | Reduce renewal coverage. Implement capital restoration plan | The matching engine enforces these bands on-chain: capacity that would push CAR below the 1.2 floor cannot be allocated. Manual intervention is possible for edge cases but the baseline protection is automatic. ### Effective leverage framework Effective leverage is the bridge between available capital and coverage capacity. It is bounded by explicit floor and ceiling values, with a target range in between: | Parameter | Value | | ---------------------- | ------------ | | Minimum leverage | 1.5x | | Maximum leverage | 5.0x | | Target operating range | 2.5x to 4.0x | | Launch operating range | 2.0x to 2.5x | Effective leverage moves within these bounds based on portfolio diversification. `Effective Leverage = Nominal Leverage × Diversification Factor` Where Nominal Leverage is the unadjusted ratio of total coverage to available collateral, and the Diversification Factor adjusts for portfolio concentration. ### Diversification Factor in depth The Diversification Factor (DF) sits between 0 and 1. Higher values indicate greater diversification and allow higher effective leverage. DF is calculated from weighted concentration scores across the portfolio's layers. Concentration is measured across four dimensions: | Dimension | Metric | Effect on DF | | -------------- | ----------------------------------------------------- | ---------------------------------------------------------------------------------------- | | Protocol | Herfindahl-Hirschman Index (HHI) of protocol exposure | Lowers DF when concentrated in a small number of protocols | | Asset | HHI of underlying asset exposure | Lowers DF when coverage concentrates in one asset class | | Exposure group | Maximum single exposure group as % of portfolio | Penalizes concentration in correlated clusters (for example, shared oracle dependencies) | | Strategy | HHI of strategy types | Lowers DF when coverage concentrates in a single strategy pattern | #### HHI concentration bands | HHI range | Concentration level | Score contribution | | -------------- | ------------------- | ------------------ | | 0 to 1,500 | Low (diversified) | 0.0 to 0.2 | | 1,500 to 2,500 | Moderate | 0.2 to 0.5 | | 2,500 to 4,000 | High | 0.5 to 0.8 | | Above 4,000 | Very high | 0.8 to 1.0 | ### Realized DF in practice Practical Diversification Factors typically fall between 0.5 and 0.7, producing effective operating leverage of 2.0x to 3.5x for a well-managed portfolio. Pushing DF higher than 0.7 requires a genuinely diverse portfolio across protocols, assets, and strategies, which is hard to achieve given the concentrated nature of DeFi liquidity.. ### Stress testing Because part of available capital is denominated in volatile assets, price drawdowns can push CAR lower without any claim activity. The protocol continuously stress-tests CAR against collateral drawdown scenarios: | Drawdown scenario | Post-drawdown CAR behavior | | ----------------- | --------------------------------------------- | | 0 to 15% | CAR remains in Adequate band | | 15 to 30% | CAR drifts toward the Watch band | | 30 to 40% | CAR enters Watch, approaches Warning | | 40 to 55% | CAR enters Warning. New coverage paused | | 55%+ | CAR enters Critical. Renewals also restricted | These bands assume a specific starting leverage and buffer size. As portfolio diversification improves, CAR becomes more resilient to the same drawdown percentage. ### The self-correcting mechanism CAR, leverage, and diversification interact in a self-correcting loop: * Improving diversification raises DF, raises effective leverage, lowers the Solvency Capital Requirement, and improves CAR. * Rising concentration lowers DF, tightens effective leverage, raises the Solvency Capital Requirement, and deteriorates CAR. This means the protocol naturally slows down when it is carrying too much concentrated risk, and accelerates when the portfolio is well balanced. ### Dynamic incentives during drawdowns During periods of collateral drawdown, the protocol can temporarily increase base rate emissions to attract incremental capital. This supports capital restoration without impairing existing coverage obligations. The mechanism is a demand-side response to improve CAR rather than a forced reduction of coverage. ### Why Firelight operates conservatively at launch At the feature-complete launch, Firelight will: * Operate with a modest portfolio (relatively concentrated by HHI standards). * Carry a conservative CAR target of 1.75 to 2.0. * Operate well within the 2.0x to 2.5x leverage band. This produces significant capital headroom and means that even severe collateral drawdowns (50% or more) would not immediately threaten in-force coverage obligations. As diversification improves over time, the protocol can move toward its target operating range. ### Where to read next * [Risk and Exposure](/for-stakers/risk-and-exposure.md) explains how these mechanics affect stakers. * [Pricing](/for-program-operators/pricing.md) covers how leverage and capital cost feed into premium. --- # Agent Instructions This documentation is published with GitBook. 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