Liquidation Discount
Definition
The Exchange Rate Liquidation Discount is the discount to the Chainlink oracle price at which liquidators can purchase collateral assets to recapitalize risky accounts. Exchange Rate Liquidation Discounts are only applied to collateral currencies.
The purpose of the Exchange Rate Liquidation Discount is to incentivize liquidators to purchase a risky account's collateral assets in exchange for repaying part of the account's debts.
In order to reliably attract liquidators, the liquidation discount must be sufficiently high to cover a liquidator's liquidation costs. A flash liquidator's expected P&L is a function of the following elements:
Exchange Rate Liquidation Discount;
Price Basis: the difference between the market price and the oracle price;
Gas Fees: ETH gas fees required to execute the liquidation transaction;
Dex Fees: AMM fees (e.g., 0.3% on Uniswap’s ETH/USDC pair);
DEX Slippage: Price impact of the swap on an AMM;
Flash loan fees: Cost to flash borrow.
Let’s note that during the liquidation process, the maximum of the two liquidation discounts associated with the debt and collateral currencies is used as the effective liquidation discount. For example, suppose a liquidator wants to liquidate an account's ETH collateral position in exchange for repaying the account's USDC debt. If ETH's liquidation discount is 8% and USDC's liquidation discount is 4%, the higher of the two discounts (8%) would be the effective liquidation discount. This methodology ensures that the liquidation discount appropriately compensates liquidators.
Liquidation discount selection process
Step 1 - Simulate a liquidator's P&L under multiple assumptions
The asset onboarding parameter selection spreadsheet includes a liquidation P&L simulation tool. The tool allows to simulate a liquidator's expected liquidation cost as a % of the liquidated collateral position under various assumptions (ex: ETH price, gas fees, slippage etc).
To use the simulator, one needs to input:
The maximum expected price basis between the oracle price and the market price (usually within +-2%). The price basis will partly vary based on the chainlink update time/maximum deviation. The price basis could be higher for currencies where a combination of oracles is used.
The ETH price.
Gas prices under various market conditions (ex: 100, 200, 500, 1000 GWEI).
The expected Liquidation gas cost.
The expected slippage cost to trade the liquidated collateral position for stablecoins.
The expected DEX trading fees to trade the liquidated collateral position for stablecoins.
The size of the collateral position to liquidate.
Liquidation portion (40% is the default liquidation portion, but it could go up to 100% if an account is heavily undercollateralized).
The simulation tool allows for a better understanding of when liquidations are profitable. Liquidators need to have a positive P&L under stressed market conditions (ex: negative price basis, high gas fees, and high slippage) to maximize the likelihood of orderly and timely liquidations. Fast and orderly liquidations are key to protecting the protocol against bad debts.
Step 2 - Backtest the selected liquidation discount
Validate that the selected Liquidation Discount is set high enough to provide liquidators with a profitable P&L under historical market conditions. Backtesting the liquidation discount to assess the historical profitability of a liquidator's PnL and the longest periods when the discount is not sufficient to cover a liquidator's costs is a great way to validate the robustness of the selected parameter.
Step 3 - Benchmark the liquidation discount with other protocols
Validate that the selected liquidation discount is in line with other lending protocols. Validate that the parameter is not overly conservative, thereby penalizing users and making the protocol less capital efficient.
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