Leveraged vaults expose Notional's funds to two risks: smart contract risk and economic risk.This page describes these risks and outlines the steps that Notional takes to mitigate them.
Smart contract risk
Leveraged vaults hold user funds and generally deploy them onto one or more external protocols. Smart contract hacks of external, integrated protocols or of leveraged vault code itself can potentially result in lost funds. We mitigate this risk with these measures:
External protocols must receive multiple audits from qualified firms.
External protocols must be live, hold significant TVL, use strong security practices, and maintain open lines of communication with the Notional community.
Strategy code must be audited by a qualified firm.
Strategy code must be reviewed and audited by the Notional core team.
Notional governance will place caps on exposure to different protocols and leveraged vaults
Leveraged vaults borrow funds from Notional in one currency and invest them into a strategy. In general the strategy will involve some amount of risk, meaning that the assets in the leveraged vault could decline in value. If the value of the assets in the vault falls too low, the vault is at risk of becoming insolvent.
Notional mitigates insolvency risk by liquidating leveraged vault users if their position breaches some maximum leverage threshold. Notional ensures that liquidations will successfully protect Notional’s funds with these measures:
For vaults where price risk could result in vault insolvency, assets in the vault must be readily liquidatable.
For vaults that involve trading the borrowed currency into a different currency, there must be deep on-chain liquidity for the relevant trading pairs. All assets in the vault must be convertible to the borrowed currency with less slippage than the liquidation discount.
The vault must be able to respond to changing on-chain liquidity levels in real time. If on-chain liquidity deteriorates such that the vault is no longer safely liquidatable, the vault must redeem its assets back to the borrowed currency until it has sufficiently decreased its exposure.
Notional governance sets minimum borrow amounts per account to ensure that liquidations will be profitable and occur in a timely fashion.