Bailouts: The New Normal For Managing Debt In DeFi
What if we told you we’ve designed an improved alternative to the usual DeFi auction for liquidating bad debt?
There’s about $43 billion USD of crypto assets locked into DeFi, and around 50% of that amount is subject to auction by major lending protocols depending on how the market moves. This unfortunately sets the stage for releasing a bunch of liquidity into the market during a period of turmoil — it’s hardly an optimal solution.
We don’t need to speculate about what can go wrong here, we only need to look at history. When the crypto market crashed in March 2020, MakerDAO had to auction off its MKR tokens for the first time in its history to cover approximately $5.4 million of bad debt. This is a completely undesirable situation for any DeFi project. We knew there had to be a better way to manage these kinds of issues, and that’s what led us to design the bailout mechanism.
Equilibrium’s bailout mechanism is an effective new approach for managing debt and risk within a DeFi system. Our system design introduces the role of the “bailsman.” Bailsmen are users who pledge liquidity in advance of a market decline or black swan event, and they play a pivotal role in keeping Equilibrium running smoothly. There’s no need to quickly gather liquidity when the bad debt mounts up, because our bailsmen have supplied this liquidity in the form of other crypto assets. It’s immediately available when we need it.
This post is going to walk you through three big reasons that bailouts are a more desirable mechanism for preserving the integrity of a DeFi platform. Bailouts make operations more predictable, eliminate the chance of slippage, and keep the risk of bad debt outside of the system.
We’ll unpack each of these points below, but first let’s cover how our bailout mechanism actually works.
Bailouts in principle and practice
By locking their digital assets into a separate pool (and earning passive income in EQ tokens for doing so), bailsmen supply Equilibrium with funds necessary for managing margin calls in advance. Simply put, bailsmen are third-party Equilibrium participants who are incentivized to take on liquidated debt and collateral. As you can imagine, that’s a net gain for Equilibrium’s overall stability.
We have a dedicated pool for this bailout liquidity — bailsmen provide their liquidity in advance to earn a substantive fraction of interest paid by the borrower. The interest rate fluctuates depending on several factors, including the conditions of the bailout pool, and bailout rewards fluctuate correspondingly.
The chart below shows how a multiplier applied on the interest rates that borrowers pay change. The multiplier is depending on the relative liquidity of bailsman and collateral pools. If the bailsman pool is sufficiently capitalized, interest rates will scale lower for all borrowers. If there isn’t enough liquidity in the bailsman pool in relation to overall collateral liquidity, then interest rates scale higher for all borrowers.
Every borrower on Equilibrium pays a variable interest rate largely dependent on an individual borrower’s portfolio conditions. To gauge the APR that bailsmen enjoy for protecting the system, we need to find a happy balance within the platform. The following table describes how the APR that bailsmen earn depends on the average collateralization of the borrowers’ portfolios in the system, assuming a constant level of aggregate risk for borrower portfolios (5% daily volatility of returns):
When borrowers default and get liquidated within our system, their asset portfolios and liabilities are transferred to the bailsmen. This makes the bailsmen into the bearers of liquidated debt in return for liquidated collateral. Since these bailsmen have some initial liquidity, every position within their portfolio remains solvent and the entire system maintains normal operations. Talk about a win-win!
Bailsmen can repay this debt any time they want to, but they can only withdraw from the bailout pool after first clearing any debt accumulated from liquidations proportional to their share of the bailout pool.
Bailouts make operations more predictable
Auctions are uncertain! Market makers may or may not want to participate in them. If these key players opt out, then whatever utility token is in use ends up being diluted to cover the shortfall. Neither a project’s users nor team members would be excited about that.
A common solution among lending protocols is to introduce high liquidation penalties. This allows some wiggle room when there’s no interest in liquidating bad debt on the part of the keepers and the collateral value keeps falling. This buys some time before a lending protocol has to tap into its utility token (just as MakerDAO had to dilute MKR), or find some other means to handle the insolvency.
We’ve done extensive research on how to manage this. The table below sums up our findings, describing the maximum allowable collateral drop at different levels of liquidation penalties and liquidation discounts.
By comparison, bailouts are a convenient and ready-made solution to this problem. There’s no need for auctions, penalties, or elaborate discount structures to incentivize certain types of behavior within the system. We measure collateral depreciation as expected, but unlike the penalty model above, we do so in aggregate to rate the solvency of the entire system, as opposed to merely considering parts of it.
In other words, we obtain a quantifiable answer to the question “Is there enough collateral and bailsman liquidity in the system to survive a severe drop in collateral value?” If the numbers suggest no, then we make borrowing less attractive by increasing interest rates, making bailing out more profitable at the same time. If the numbers suggest yes, then the opposite holds true: borrowers are attracted to lower interest rates while bailsmen earn less.
There’s no risk of slippage
Slippage refers to the difference between the expected price of a trade and the price at which the trade is actually executed — it’s the reason you might get less out of a transaction than you expected.
Slippage is most prevalent during periods of high volatility, when traders and market makers prefer to sit on the sidelines instead of keeping orders in the order book. Crypto assets are known for their volatility in comparison to conventional assets, so low liquidity is a frequent risk. Slippage impacts the liquidation of bad debt because, if we cannot solve it, it can lead to selling off collateral in a distressed market.
Bailouts reduce the chance of slippage to zero because no trade occurs if a position becomes insolvent. Bailsmen can handle the debt they received from liquidated borrowers at any time they want, willingly waiting through periods of high and low liquidity.
No risk of slippage, no problem.
No risk of bad debt in the system during liquidations
So far, DeFi systems have been designed such that bad debt remains in the system until third parties (like keepers and market makers) buy it out. This represents a risk of insolvency for the whole system, and that shouldn’t sit well with anyone. That’s why we introduced the bailout mechanism.
Equilibrium is uniquely protected from bad debt because the bailsmen protect borrowers from the risk of insolvency. The assets associated with a user’s collateralized debt position are completely separate from the funds for liquidating bad debt. This siloed design keeps bad debt on the outside looking in.
Think of it this way: MakerDAO’s keepers buy out bad debt (or at least are expected to do so) when it arises as the result of borrower liquidations. Meanwhile, Equilibrium’s bailsmen supply this liquidity in advance, and they furthermore have the option to manage it later on when they decide to cover the debt they’ve accumulated from liquidations.
We’re proud to present our bailout mechanism as a proactive, future-proof solution to managing bad debt.
The outline of our series:
