Collateral Discounts: a Powerful Tool to Manage Liquidity Risks
Using illiquid assets as collateral poses significant risk to the money market and the long term sustainability of the Equilibrium protocol. Polkadot is only preparing for the major lift off and many of its parachains still have low utility and low liquidity tokens which are not usually considered to be a good collateral in money market systems.
Even though Equilibrium’s unique approach allows to diversify this risk away by using collateral portfolios, we can never be sure that there won’t be any malicious actors who will use the system to opt out of their token allocations even with a penalty — a good alternative to selling tokens on a thin market.
A good initial measure which mitigates risk outlined above is a system of discounts for collateral tokens which addresses the nature and relative magnitude of risks each asset bears. Generally speaking, price predictability and lower associated risks result in lower discounts (higher coefficients when calculating collateral value), as bailsmen have a high degree of certainty that the full amount of the loan can be covered if the collateral must be liquidated. The initial set of discounts / coefficients could look something like this:
For example, EQ tokens will be counted only at 50% of their value when used as a collateral inside the Equilibrium money market. This measure will definitely curb the speculative liquidation activity and allow bailsmen to position themselves much better in the first place.
How do we assess and set discounts in practice? This is a very tough question which requires to constantly assess the instantaneous order book depth and liquidity on several CEX-es something similar to this great bitcoin tool: https://data.bitcoinity.org/markets/books/USD but for assets we support on our money market and then figuring out discounts by answering a question “how much (in percentage terms) will I move the market if I sell all of the collateral at market price on the list of supported exchanges” — e.g. what will the slippage be on a size of liquidating collateral?
It may happen so that there is too much collateral in the system in a particular asset to be effectively absorbed on the market, so further assessment needs to be done on the amount of collateral which is at the immediate risk of liquidation and which is still “safe” in terms of borrower position overcollateralization. This is another tricky question which requires thorough analysis which is currently in the making at the Equilibrium R&D department.
As you may see, the topic of setting up a correct discount is a complex subject requiring a lot of research, historical data analysis and tests with possible model building. At the end we would like to start pretty conservative and probably you may expect to see figures similar or stricter to the table above.
About Equilibrium
Equilibrium is a one-stop DeFi platform on Polkadot that allows for high leverage in trading and borrowing digital assets. It combines a full-fledged money market with an orderbook-based DEX. EQ is the native utility token that is used for communal governance of Equilibrium. xDOT is a liquid and tradeable wrapped DOT that unlocks liquidity of DOT locked in parachain auctions and delivers multiple crowdloan bonuses on Polkadot.
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