In our borrow and supply cap methodologies, we use certain factors to address the risk of price manipulation. This post explains our approach in more detail and highlights why it is important for lending protocol risk. Price manipulation occurs when an adversarial borrower affects the price of their collateral or loan tokens in the open market. Because protocols rely on market prices to determine the risk profile of loans, the user may then be able to create large amounts of debt without appropriate controls.
More specifically, an adversarial borrower has two ways to inflict losses on protocol suppliers or reserves:
- Temporarily exaggerate the value of their collateral token (called Long Manipulation)
- Temporarily understate the value of their loan token (called Short Manipulation)
Either of these actions, if successful, allows borrowing that would be undercollateralized during normal conditions. Once a large loan is made using manipulated prices, the protocol and its users will likely suffer losses as markets revert to normal. Since there is often no way to recover borrowed tokens, protocols must preemptively stop or discourage these exploits.
This is where caps are a powerful tool. By limiting the usable collateral (or loan) tokens, supply (or borrow) caps also limit the payout of a successful manipulator. Due to the initial cost of moving markets, price manipulation can only be profitable at large exploit sizes. Caps that prevent this size then remove the economic motive to manipulate, even for users with plenty of capital to do so. Borrow and supply caps should therefore be set to ensure that adversarial users cannot break even.
Our methodologies estimate the required size for profitable long and short manipulation based on liquidity depth in the underlying markets. For both types of manipulation, we model the cost to move markets enough to open an undercollateralized loan. We then determine the caps needed to make profits on such attempts highly unlikely. Supply caps are set to protect from long manipulations of collateral tokens, and borrow caps to protect from short manipulation of loan tokens. By blocking the upside of potential exploiters, carefully managed borrow and supply caps serve as a key line of defense against price manipulation.
