Liquidity Risk

Illiquid and volatile assets leave the protocol in risk of bad debt. For example, if an asset needs to be liquidated, there must be enough liquidity for a profitable liquidation to occur. If the potential slippage for liquidating an asset is too high, then a profitable liquidation will not happen, leaving the protocol in debt, and forcing additional systemic risk mitigation mechanisms to take place such as XY slashing.

To prevent this from happening, there are a number of precautions put in place. As the risk methodolgy table shows, factors such as market cap, and liquidity (overall liquidity + buyside / sellside price impact) encompass a high percentage of an asset’s overall risk score. The protocol's novel Proof-of-Liquidity concept also significantly reduces the likelihood of bad debt. These are then used to help determine the risk parameters of an asset, including max LTV and liquidation threshold.

In general, the lower the risk score of an asset is, the lower the max LTV and liquidation threshold for the isolated module will be. This risk score is also used to determine XY allocation for an isolated module. A low XY debt ceiling for an isolated module is another precautionary measure to lower the amount of potential bad debt. To account for asset volatility, while assets with weak risk scores will have low max LTV rates, there will still typically be a buffer of around 10% from the max LTV percentage to the liquidation threshold percentage. This is so that user positions in these isolated modules are not being liquidated too frequently, while the liquidation threshold is set low enough for profitable liquidations to occur.