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Cash refers to assets deposited in Notional V2 such as compound cTokens (e.g., cDAI, cETH, cWBTC) or Aave aTokens. Cash can be used as collateral in Notional V2. As an example, an account could borrow fUSDC against cETH collateral.
If the cross-currency exchange rate between an account's collateral currency and debt currency declines and an account's free collateral value turns negative as a consequence; a portion of the account's collateral currency will be put up for liquidation at a discount to its price.
The size of the moves in the cross-currency exchange rates that the protocol can withstand before an account becomes undercollateralized is dictated by the Exchange Rate Haircuts & Buffers and the Exchange Rate Liquidation Discounts.
The exchange rate liquidation discounts are the discounts to the Chainlink oracle prices at which liquidators can purchase a collateral currency to recapitalize an account having a collateral requirement.
Let’s note that during the liquidation process, the maximum of the two discounts associated with the borrowing and collateral currency is used for the liquidation calculation. This methodology ensures that the liquidation discount is appropriate as they vary significantly for different currency pairs.
The purpose of the Exchange Rate Liquidation Discounts is to provide an incentive for liquidators to buy an undercollateralized account collateral currency in a currency where the account has a collateral requirement.
In order to reliably attract liquidators, they must expect liquidations to be profitable. If they use flash loans to execute liquidations on Notional, their profit will be a function of the following elements:
- The exchange rate liquidation discount;
- The price basis: the difference between the market price and the oracle price;
- Gas fees: ETH gas fees necessary to complete the liquidation transaction;
- Exchange fees: AMM fees (e.g., 0.3% on Uniswap’s ETH/USDC pair);
- Slippage: Price impact of a swap on an AMM or of an nToken redemption.
The exchange rate liquidation discounts have been selected based on our analysis of historical expected liquidator profits and our appreciation of idiosyncratic liquidation risk factors.
We selected a 4% liquidation discount for USDC and DAI cash groups as stablecoin cross-currency pairs price basis, AMM fees and slippage have historically been lower than for other crypto-assets and are qualitatively expected to be less volatile.
We selected an 6% liquidation discount for ETH as it is more volatile than stablecoins.
We selected a 7% liquidation discount for WBTC as its liquidation could necessitate multiple swaps, thus increasing gas fees. Furthermore, slippage on WBTC pairs has historically been higher than for ETH pairs.
As a benchmark for the selected parameters, here are the liquidation discounts or liquidation penalties currently used by other lending protocols:
Exchange rate haircuts are applied to positive local currency collateral values, while the exchange rate buffers are applied to negative 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 sudden changes in cross-currency exchange rates that could lead the protocol to become under collateralized. As an example, if an account free collateral value becomes negative due to a decline in the cross-currency exchange rate and the decline continues before a liquidator can effectively recapitalize the account, the haircuts and buffers would ensure that the protocol would be sufficiently capitalized as long as the exchange rate move is lower than the implied buffer and haircut protection for the pair.
Exchange Rate Haircuts and Buffers allow Notional’s governance to mitigate this under collateralization risk by recognizing only part of the collateral and debt currencies' value during the free collateral calculation.
Impact of Exchange Rate Haircuts and Buffers during the free collateral calculation on a 5 ETH debt collateralized by 1 BTC:
Exchange rate haircut and buffer values have been selected based on historical maximum drawdown measures in the cross-currency exchange rates. We analyzed the 3 hour and 6 hour cross-currency exchange rate maximum drawdown measures (a period expected to be sufficient for liquidators to liquidate negative free collateral accounts) to validate the robustness of the selected parameters.
Moreover, the selected exchange rate haircut and buffer values have to ensure that the liquidation of any cross-currency pair increases the free collateral value of the liquidated account. To ensure that liquidations increase the free collateral value of an account, the following condition must hold true for all cross-currency pairs:
Based on this condition, qualitative risk factors, and the historical 3 hour and 6 hour maximum drawdown measures, we selected the following exchange rate haircut and buffer values:
Based on these exchange rate haircut and buffer values, the protocol could bear cross-currency variations the magnitude of a pair’s respective haircut and buffer values even if both moves occurred simultaneously. We hereafter present the maximum withstandable decrease in the collateral/debt cross-currency exchange rate taking into account the liquidation discounts for all currency pairs:
As showcased above, the cross-currency exchange rate moves that the WBTC/ETH can withstand is larger than for other pairs since both currencies (ETH and WBTC) have a large haircut and buffer values individually. Although an individual ~24% move in the value of either WBTC or ETH against a stablecoin is probable, a 35% decrease in the ETH / WBTC is highly unlikely.
This is because our methodology does not account for positive correlation benefits between currencies. If the ETH/BTC correlation were reliably high (implying a lower volatility exchange rate), the selected haircut and buffer values would be overly conservative for that pair.