I want to borrow, but what happens if the price of my collateral changes?

When the price of your collateral changes, your collateralization ratio changes. If your collateralization ratio falls below the minimum 140%, you become eligible for liquidation. During liquidation, a liquidator purchases a portion of an account’s collateral at a discount to the on-chain oracle price and repays some of the liquidated account’s debt. The portion of collateral that the liquidator can purchase is calculated to return the liquidated account to the minimum collateralization ratio.

Here’s an example:

  1. A borrower deposits 1 ETH as collateral with a ETH/USDC exchange rate of 1,000.

  2. The borrower then borrows 500 USDC. Their collateralization ratio is 200% because the value of their collateral is twice the value of their debt.

  3. The ETH/USDC exchange rate falls to 700. Their collateralization ratio is now 140%.

  4. The ETH/USDC exchange rate falls to 600. The borrower’s collateralization ratio is now 120% and they are eligible for liquidation.

  5. A liquidator purchases a portion of the borrower’s ETH at a discount to the on-chain oracle price and places USDC in their account. The liquidator purchases just enough of the borrower’s ETH to return them to the minimum 140% collateralization ratio.

In this example, the liquidator purchases about 0.52 ETH for 294 USDC. This leaves the borrower with 0.48 ETH, an outstanding debt of 206 USDC, and a collateralization ratio of roughly 140%.

Is there a repayment penalty for exiting my loan early?

You can exit your loan at any time without penalty. When you repay your debt, you pay back your principal and any interest that you have accrued to that point. Additionally, you close out the remainder of your loan at the prevailing interest rate. Changes in the prevailing interest rate can affect how much money you make if you choose to exit your position early.

You can think about closing out a borrow as executing an offsetting lend. For example, if you borrow 100,000 DAI for six months at 4% and then close out three months later at the now prevailing interest rate of 8%, you will have accrued 1,000 DAI in interest over those first three months. But you will also make money on the remaining three months of your loan because you will offset your 4% borrow with an 8% lend. By closing out early in this scenario, you earn the 4% interest rate differential on your remaining three months and it offsets the interest that you paid in the first three months!

Does lending and borrowing happen in one transaction?

In most scenarios, yes. Notional has designed the protocol to minimize user friction as much as possible. You can lend, borrow, provide liquidity, withdraw liquidity or cash into your wallet, repay debts, withdraw loans, or roll assets from one maturity to another, all within a single transaction.

What happens if I don't pay back my debt by maturity?

If you don’t repay the debt you owe to the protocol at maturity, you will be eligible for settlement by a third party. In a process similar to liquidation, a third party can buy a portion of your collateral at a small discount to the on-chain oracle price and settle your debt on their behalf.

You can roll your debt to a future maturity at the prevailing interest rate for that maturity at any time. This means that you don’t need to settle your debts if you do not choose to do so.

Enforcing the repayment of debt at maturity allows Notional to ensure lenders that they will be able to redeem their fCash for the underlying currency that they are entitled to.

Is lending the same thing as providing liquidity?

No. Lenders trade cash for fCash and earn a fixed interest rate. Liquidity providers capitalize Notional’s liquidity pools and earn variable trading fees. Each time a lender lends or a borrower borrows, they pay a transaction fee to liquidity providers in that pool.

Notional liquidity pools are similar to Uniswap pools in that there are buyers, sellers, and liquidity providers that facilitate trading. In the case of Notional, buyers and sellers are lenders and borrowers. Liquidity providers facilitate that lending and borrowing and earn transaction fees as compensation.

What is slippage?

Every time a user lends or borrows, the prevailing interest rate on the market changes. The difference between the current interest rate and the interest rate that a user gets on their loan is called slippage. The magnitude of a user's slippage is dependent on the size of their loan relative to the amount of liquidity in the market. A larger loan incurs greater slippage.

What is the best collateral ratio to borrow at?

The collateral ratio you choose determines the likelihood that your collateral gets liquidated. The lower your collateral ratio, the greater your risk of liquidation. Choosing the right collateral ratio for you depends on how much risk you want to take and how actively you plan on managing your positions. Here are a few example personas and the ratios they might choose:

The occasional DeFi user: 250% - 300%+ This user doesn’t want to be bothered keeping a close eye on their collateralization ratio. They don’t check the UI every day and are more concerned with peace of mind rather than optimizing their leverage. Setting a collateralization ratio in this range gives the user confidence that they mostly don’t need to worry about getting liquidated and only need to top up their balances if there is a significant market decline.

The active DeFi user: 180% - 200% This user tracks their positions and uses DeFi products every day but has no automated collateral management system. This user keeps close tabs on their collateral positions but knows that big price moves can happen overnight. Building in a buffer gives this user confidence that their collateral won’t be liquidated before they are able to top up their balances.

The professional: 150% - 160% This user is a professional who manages their collateral positions across DeFi with the help of an automated system. This user wants to get as much leverage as possible out of their collateral. They are comfortable with an aggressive collateral ratio because they know that their system automatically tops up their collateral if they approach the minimum collateralization ratio.

What risks do lenders take?

Lenders face two risks. The first risk is that the protocol could become insolvent because some borrowers have become insolvent. If this were to happen, the protocol might not hold enough cash to pay out lenders. Our robust liquidation protocol and infrastructure minimizes this risk, but it is still possible. In the event that Notional’s liquidation procedure allows a borrower to become insolvent, we have an on-chain reserve fund to help cover any losses that might arise on the platform.

The other risk lenders face is that the smart contracts could get hacked. We take security extremely seriously and take every possible measure to ensure that this won't happen. Our system has been audited by the industry leader OpenZeppelin. View the Notional Protocol Audit report.

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