fCash risk adjustments
fCash is Notional's zero-coupon bond-like instrument and derives its value from time to maturity and current interest rate levels.
fCash assets are thus a claim to a cash flow at a specific point in the future (e.g. 1 fUSDC can be redeemed for 1 USDC upon maturity). The value of positive fCash assets decreases when interest rates increase. Conversely, the value of negative fCash assets decreases when interest rates decrease.
fCash assets can be used as collateral and debts in Notional V3. Consequently, an account holding fCash could get liquidated as the value of fCash changes. In order to sell fCash collateral at a discount in the context of a liquidation, the Notional protocol needs to be able to value fCash assets and risk adjust fCash in order to protect the protocol against potential changes in price.
Oracle rate
In order to mitigate the risk of fCash price manipulation, Notional uses oracle interest rates to value fCash assets. Notional oracle rates act as lagged, dampened price feeds that converge to the last traded interest rate over a time window.
Oracle rate time window
If the oracle rate time window is too narrow, an attacker could either lend or borrow in order to manipulate a pool’s oracle rate. If no capital is deployed by other market participants over the duration of the time window, an attacker could effectively manipulate an interest rate until an account or a set of accounts become eligible for liquidation.
Increasing the time window decreases an attacker’s probability of success. It increases the attacker’s cost as he would have to manipulate the interest rate for a longer time period and thus take more risk.
The downside of using a longer oracle time window is that the protocol will be slower to react to changing interest rates. This could hinder the protocol's ability to successfully liquidate undercollateralized accounts as these accounts would only be eligible for liquidation after a longer time period.
To mitigate the oracle rate unresponsiveness risk, governance can select larger fCash haircuts and buffers for the protocol to be able to withstand pronounced changes in interest rates.
Oracle rate time window parameter selection considerations
When selecting the length of the oracle rate, governance needs to mitigate the risk of potential oracle rate attacks while still ensuring the responsiveness of the protocol.
fCash haircuts & debt buffers
fCash haircuts and Debt buffers are adjustments made to the oracle interest rate denominated in 5 bp increments (i.e. a value of 10 would equate to 50 bps) used to risk adjust the value of positive fCash balances (fCash haircut) and negative fCash balances (debt buffer) during the free collateral calculation.
Purpose of the fCash haircuts & debt buffers
The purpose of the fCash haircuts & debt buffers is to mitigate interest rate risk when computing the value of fCash assets as collateral or debts.
For example, an interest rate increase would lower the present value (PV) of a positive fCash position. fCash haircuts allow the protocol to value positive fCash assets at a lower value than the market value. For example, if the oracle rate for fUSDC 1Y is 5% (PV of 0.95 USDC) and the fCash haircut is 5% then the fCash would be valued at 10% (PV of 0.90) for risk purposes. The adjustment protects the protocol against an increase in the oracle interest rate.
Conversely, a decrease in interest rates would increase the PV of negative fCash positions (fCash debts). fCash debt buffers allow the protocol to value negative fCash debts at a higher value than their market value, thereby protecting the protocol against decreases in interest rates. For example, if the oracle rate for fUSDC 1Y is 5% (PV of 0.95 USDC) and the fCash debt buffer is 5% then the fCash would be valued at 0% (PV of 1.0) for risk purposes. Note that risk-adjusted oracle rates can't go negative such that the maximum risk-adjusted value for fCash debts is 1.0.
fCash haircuts & buffers liquidation discounts
Liquidations of fCash assets are conducted at a discount to the oracle rate. fCash liquidation discounts act as an incentive for liquidators to recapitalize accounts with collateral requirements. For example, if an account's fCash haircut liquidation discount is 1.5% and the current market interest rate for 1 year fCash is 5% (PV of 0.95) then a liquidator could purchase fCash at a PV of 0.935. A liquidator could therefore purchase fCash below market prices and sell the acquired fCash using Notional's liquidity pools.
Parameter selection considerations
Governance needs to select fCash liquidation discounts that represent a sufficient incentive to attract liquidators and should cover the expected trading costs (gas fees and bid-ask spread) associated with the liquidation of an fCash position. The fCash haircut liquidation discount must be smaller than the fCash haircut and is denominated in 5 bp increments (i.e. a value of 10 would equate to 50 bps). Similarly, the fCash buffer liquidation discount must be smaller than the fCash buffer.
Maximum and Minimum Oracle Rates
Since fCash interest rates can increase upwards of 30%, the protocol sets a maximum oracle interest rate when valuing fCash debts to avoid the possibility of an attacker increasing rates momentarily artificially lower the value of his debts.
Conversely, Notional's governance can set minimum oracle rates at which fCash collateral balances will be discounted at. This minimum rate ensures that fCash assets are always discounted to a given rate.
Max Discount Factor
Short-dated fCash is subject to be valued close to par (ex: 1 fCash being worth 0.9999 of the underlying) as it approaches maturity. The max discount factor allows Notional's governance to set an absolute maximum value for fCash assets (positive fCash).
The max discount factor is denominated in 5 BPS. A max discount factor of 40 would imply that positive fCash assets can't be valued at more than 0.98 of the underlying currency's value.
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