Exchange Rate Risk

Exchange rate liquidation discounts

Exchange rate liquidation discounts specify the discounts to Chainlink oracle prices at which liquidators can purchase undercollateralized accounts' collateral assets.
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. For example, if a user holds ETH collateral against a USDC debt and the liquidation discounts are 6% for ETH and 4% for USDC then the effective liquidation discount will be 6% as it is the higher of both currencies. This methodology ensures that the liquidation discount is appropriate as they vary significantly for different currency pairs.

Purpose of the Exchange Rate Liquidation Discounts

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 at which the liquidator will sell the collateral asset and the oracle price at which the liquidator will purchase the collateral asset;
  • Gas fees: ETH gas fees necessary to complete the liquidation transaction;
  • Exchange fees: DEX fees (e.g., 0.05% on Uniswap’s ETH/USDC pair);
  • Slippage: Price impact of a swap on a DEX or of an nToken redemption.

Parameters selection considerations

Exchange rate liquidation discounts should be selected by governance based on an historical analysis of expected liquidator profits and an appreciation of idiosyncratic liquidation risk factors. Governance should backtest the robustness of the selected liquidation discount by looking at historical market conditions.
Selected liquidation discounts should also be benchmarked against other lending protocols to validate that Notional liquidation penalties are not overly penalizing.

Exchange rate haircuts and buffers

Exchange rate haircuts are applied to positive local currency collateral values. In contrast, exchange rate buffers are applied to negative local currency collateral values when converting them to ETH during the free collateral calculation.
Exchange rate haircuts are applied to net collateral positions. This means that even if an account has a debt in a currency, as long as the account holds a larger risk-adjusted collateral position in that same currency, the exchange rate haircut will be applied.
If the net risk-adjusted position for a given currency is negative (a debt), then the exchange rate buffer is applied.

Purpose of the Exchange Rate Haircuts & Buffers

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 undercollateralized. For example, if an account's free collateral 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 still 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 under collateralization risks by recognizing only part of the collateral and debt currencies' value during the free collateral calculation.
In the following diagram, we illustrate the impact of Exchange Rate Haircuts and Buffers during the free collateral calculation. In this example, the account holds a 5 Prime ETH debt collateralized by 1 Prime WBTC:
By haircutting collateral assets and buffering debts, the Notional protocol can independently mitigate risks associated with the price volatility of assets and debts. This means that different collateral/debt combinations will imply different maximum LTVs.
Because Notional's collateral framework does not account for positive correlation benefits between currencies, max LTVs for correlated pairs such as ETH/BTC are overly conservative. For these currency pairs, governance can list cross-currency fCash leveraged vaults to offer higher max LTV pairs to users.

Parameter selection considerations

Governance should consider historical maximum drawdown (ex: 1 hour, 6 hour, 24 hour) measures in the cross-currency exchange rates when selecting Exchange rate haircuts and buffers. The maximum drawdown period should be long enough for liquidators to liquidate undercollateralized accounts profitably.
Additionally, the selected exchange rate haircut and buffer values should 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:
debtCurrencyBuffer>liquidationDiscountcollateralCurrencyHaircutdebt Currency Buffer > liquidation Discount * collateral Currency Haircut

Other considerations

Other factors, such as asset centralization risks and other qualitative risks, should also be taken into account by governance when selecting Exchange Rate Haircuts and Buffers.

Current parameters

Based on the selected Exchange Rate Haircut and Buffer values, the protocol could bear cross-currency variations in the magnitude of a pair’s respective haircut and buffer values, even if both moves coincided. This spreadsheet presents the protocol's maximum withstandable decrease in the cross-currency exchange rate and max LTVs for all collateral/debt pairs based on current parameters.