As a DeFi lending protocol Notional is subject to multiple economic risks.
Asset price volatility impacts the value of a borrower’s collateral assets and debts over time. Price fluctuations can make the value of an account's debts become larger than the value of an account's collateral assets. Notional mitigates this risk by liquidating accounts when they are deemed too risky. The threshold at which an account is deemed too risky is based on asset price volatility and is implemented using collateral haircuts and debt buffers.
Oracle Price Risks
Notional relies on price oracles (Chainlink adapters) to assess the value of collateral assets and debts. Oracle risks show up in two ways.
First, oracles can be manipulated to trick the protocol into thinking that a borrower’s collateral assets are worth more than their true value or that debts are worth less than their true value. This is one of the most common attack vectors in DeFi lending.
The other major risk the protocol faces with price oracles is that updates can lag and differ from actual market prices or even report inaccurate prices. If an oracle is too slow to update during a market drawdown, liquidators could be unable to liquidate risky accounts profitably until there is a new oracle price update. Additionally, if oracles stop updating altogether, the protocol could become paralyzed, and liquidators could be unable to liquidate risky accounts profitably.
As a lending protocol, Notional is also subject to liquidity risks in two fundamental ways.
The first is collateral asset liquidity risk.When an account is deemed too risky and becomes eligible for liquidation, Notional relies on liquidators showing up and buying the account's collateral assets at a discount to their oracle prices. If the slippage for liquidators to convert the collateral assets into the debt currency is too high, then it will be unprofitable for them to liquidate the account. The protocol may accrue bad debts as a result.
Notional is also subject to lending liquidity risks. As a lending protocol, Notional must ensure that the assets that are being lent can be redeemed if necessary. Lending protocols usually mitigate this risk by increasing the lending and borrowing interest rates when utilization is high to incentivize users to supply additional liquidity and incentivize borrowers to repay their debts.
Counter-party & Centralization Risks
Assets listed on Notional are subject to counter-party risk. For example, governance tokens listed as collateral might face centralization risks. Other assets like stablecoins might face the risk of blacklisting or custody risk.