Exchange Rate Haircut & Buffer
Definition
Exchange rate haircuts are applied to positive local currency collateral values when converting them to ETH during the free collateral calculation.
Exchange rate haircuts and buffers aim to protect the protocol against asset price changes. For example, if an account becomes eligible for liquidation, exchange rates haircuts and buffers will protect the protocol against declines in the account's collateral asset value and increases in the account's debt value. Exchange rate haircuts and buffers allow the protocol to remain overcollateralized while waiting for liquidators to liquidate risky accounts.
Exchange Rate Haircuts mitigate this under collateralization risk by recognizing only part of an account's collateral asset value during the free collateral calculation. Similarly, Exchange Rate Buffers inflate the value of an account's debts.
Using Exchange Rate Haircuts and Buffers, one can calculate the minimum collateral ratio of a given cross-currency pair as follows:
For example, if the Exchange Rate Buffer for USDC is 1.09 and the Exchange Rate Haircut for ETH is 0.78, the Minimum Collateral Ratio would be 1.09/0.78 = 140%
Exchange Rate Haircut selection process
Step 1 - Collect historical price data and calculate volatility metrics
Collect the asset's historical prices on an hourly basis. Chainlink oracle prices are generally an appropriate data source, but other on-chain data sources can be used.
Using historical prices one can compute the following metrics:
Historical volatility,
Historical maximum drawdown,
Historical return distributions.
Step 2 - Select an appropriate minimum collateral ratio
Analyze the historical volatility table, the historical max drawdowns, and the historical return distributions. Based on the asset's characteristics, one can determine a minimum collateral ratio that protects the protocol against rapid changes in the collateral asset price. The selected minimum collateral ratio should also consider the payment of the liquidation discount to liquidators. For example, one can compare the minimum collateral ratio (excl. the liquidation discount) to historical maximum drawdown measures to ensure it protects the protocol against rapid asset price changes.
Other notable risks (ex: centralization risks) that surfaced during the asset onboarding risk assessment should be taken into account when selecting an asset's proposed minimum collateral ratio.
Step 3 - Select the Exchange Rate Haircut
Select an Exchange Rate Haircut that enforces the minimum collateral ratio determined in step 2.
Validate that the Exchange Rate Liquidation Discount and the Exchange Rate Haircut satisfies the following condition:
This condition ensures that the liquidation of any cross-currency pair increases the free collateral value of the liquidated account. The condition must hold true for all cross-currency pairs. The debtCurrencyBuffer used in the above calculation should usually be USDC's.
Step 4 - Benchmark the Exchange Rate Haircut with other protocols
Validate that the selected Collateral Ratio implied by the selected Exchange Rate Haircut is in line with other borrowing/lending protocols (ex: Aave, Maker, or Compound) and not overly aggressive/conservative.
Exchange Rate Buffer selection process
Exchange rate buffers are only necessary for assets that will be allowed to be borrowed from the protocol. These are assets where Prime Cash borrowing is enabled.
A similar process to the Exchange Rate Haircut selection process is required to select the asset's Exchange Rate Buffer. Exchange Rate Buffers protect the protocol against potential increases in the value of an account's debts. To select the minimum collateral ratio at which users should be able to deposit USDC and borrow the onboarded asset, one can look at historical volatility measures and historical maximum drawup measures.
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