Leveraging nTokens example

nTokens can be used as collateral in Notional V2. In order to protect the protocol against a potential decline in the value of nTokens used as collateral, nTokens are haircut by 20% during an account free collateral calculation. Read more about free collateral here.

As an example, if an account mints 100 K$ of nTokens, its account value will be 100 k$ but its free collateral value will be 80 K$. This means that an account with an initial deposit of 100 K$ could lever up on its nTokens by borrowing against its free collateral to subsequently mint additional nTokens.

Leveraging nTokens considerations

Before leveraging up on nTokens, LPs should consider the following points:

• An nToken's NPV can decrease as residuals get larger

• An nToken's redemption cost increases as residuals get larger

LPs using lots of leverage could see their account's free collateral value turn negative and be eligible for liquidation if the collateral value of their nTokens decreases. It is important to note that the conditions under which an nToken's NPV decreases (positive residuals and increasing interest rates or negative residuals and decreasing interest rates) are the same conditions under which nToken redemptions are the costliest. It is important for users to take this into account in order to lever up responsibly and mitigate the risk of getting liquidated.

Example

We will look at two accounts, one will low leverage (account #1) and one with high leverage (account #2). In this example, nTokens are haircut by 20% and the initial borrowing rate on the one year fUSDC is set at 5%.

LP #1 actions	USDC	nUSDC	fUSDC debt (1Y)	Free collateral*
Initial position	100,000	0	0	100,000
Minting nTokens	0	100,000	0	80,000
Borrowing against nTokens	47,619	100,000	-50,000	77,619
Minting nTokens	0	147,619	-50,000	68,095

LP #2 actions	USDC	nUSDC	fUSDC debt (1Y)	Free collateral*
Initial position	100,000	0	0	100,000
Minting nTokens	0	100,000	0	80,000
Borrowing against nTokens	309,523	100,000	-325,000	64,523
Minting nTokens	0	409,523	-325,000	2,618

*In local currency

In the following figure we look at both accounts free collateral values following a decrease in the nToken's NPV due to an increase in fCash interest rates.

Since account #2 used a lot of leverage its free collateral value turned negative and became eligible for liquidation when the nToken's NPV decreased. Account # 1, on the other hand, used less leverage and although its free collateral value also decreased when the nToken's NPV decreased, it always remained positive and was never at risk of being liquidated.

In this example, account #2 would have been eligible for liquidation at the worst possible time as the expected returns following an increase in rates are favorably skewed. This is because when rates increase nTokens earn a higher blended interest rate. Moreover, when rates are high and LPs mint additional nTokens, the nToken account will lend to the different pools at a high interest rate.