As explained in the nToken section, the value of nTokens can decrease and therefore does not monotonically increase over time.
If an nToken holder borrows against its nTokens and the value of nTokens subsequently decreases in value, the nToken holder's account could become undercollateralized and eligible for liquidation.
The size of the move in the value of nTokens that the protocol can withstand and the liquidation discounts used to attract liquidators are dictated by the nToken PV Percentageand the nToken Liquidation Haircuts, respectively.
nToken liquidation haircuts
nToken liquidation haircuts are applied to the nToken PV to calculate its purchase price in the course of a liquidation.
Purpose of nToken liquidation haircuts
nToken liquidation haircuts act as an incentive for liquidators to recapitalize accounts with collateral requirements. Thus, the liquidation haircut percentage should cover the expected trading costs associated with the liquidation of an nToken position and provide a sufficiently large additional premium as a liquidation incentive for liquidators.
For example, if the nUSDC liquidation haircut is 98%, a liquidator could purchase nUSDC from an undercollateralized account at a 2% discount to the nUSDC value.
nToken PV Haircut Percentage
The nToken Haircut Percentages are applied to the nToken PV in the course of the free collateral calculation.
Purpose of the nToken PV Haircut percentage
The purpose of the PV haircut percentage is to mitigate the risk the protocol could face from a decrease in the collateral value of nTokens.
The PV haircut percentage allows Notional’s governance to mitigate this under collateralization risk by applying a haircut to the value of nTokens thus recognizing only part of their value as collateral. Haircuts increase Notional’s ability to withstand the liquidation of a liquidity provider’s nTokens following a sudden change in interest rates or exchange rates.
For example, if the nToken PV haircut percentage for nUSDC is 0.9 and the current value of nUSDC is 1.1, the risk adjusted value of nUSDC for collateral purposes would be 0.99 (0.9 * 1.1) USDC.
The PV haircut percentage also operates as a limit to the amount of leverage liquidity providers can take using their nTokens as collateral.