Proof-of-Liquidity
Explaining Proof-of-Liquidity and how it helps risk management
Last updated
Explaining Proof-of-Liquidity and how it helps risk management
Last updated
Proof-of-Liquidity is a mechanism for dynamically assessing collateral value by leveraging the underlying liquidity of tokens, ensuring a more accurate and liquidatable asset valuation compared to traditional quote price methods.
Throughout the history of lending protocols in DeFi, there have been instances where users have been able to take out large loans with collateral in amounts that are effectively unliquidatable. This is because there is an insufficient amount of on-chain liquidity to absorb the liquidation of the collateral asset, and would cause significant slippage leading to a highly unprofitable liquidation. In such a situation, the lending protocol is left hoping that the user can increase the loan position's health factor, or for external liquidators to step up and take on the collateral asset. If either of these scenarios do not happen, the protocol is left with a significant amount of bad debt.
Proof-of-Liquidity is designed to prevent such scenarios. By dynamically assessing the underlying liquidity of collateral assets, the protocol can set more effective risk parameters, along with appropriate debt ceilings that are correlated with liquidatable liquidity.
The equation above is the Constant Product Formula, used by AMMs for liquidity pools, where X and Y are the quantities of two different tokens in a liquidity pool. As the value of one token decreases due to more people selling the token in the liquidity pool over the other token, its supply increases comparatively.
Let's say that asset Y was listed as a collateral asset on a lending protocol. Assets X and Y were initially pooled together with the same price and same quantity. As selling pressure on asset Y is increased, or buying pressure on asset X is increased, asset Y's supply increases compared to asset X. Buying pressure on asset X is not a problem, but continued selling pressure on asset Y is. As this happens, the liquidatable value of asset Y decreases. If this continues to happen, then there comes a point where there is not enough asset X liquidity, and asset Y becomes virtually unliquidatable.
It's important for lending protocols to track such developments in an automated way. Otherwise, deposited collateral assets with high debt ceilings can become unliquidatable, leaving the protocol in bad debt.
Before any assets are listed as collateral on Tren Finance, a Proof-of-Liquidity check is conducted to assess the true liquidity of an underlying asset. This is then used to help determine the risk parameters and the debt ceilings of isolated modules. Proof-of-Liquidity checks are dynamically conducted to manage asset risk.
Proof-of-Liquidity is an assessment that the protocol relies upon along with more standard forms of liquidity evaluation, as shown in the Asset Risk section. Liquidity and oracle risk management are particularly aided by dynamic Proof-of-Liquidity assessments. As this assessment shows the true underlying liquidity of an asset, the likelihood of the protocol facing bad debt is drastically reduced. Exploits using oracle manipulation are also made more difficult as the cost of a price exploit can be measured more accurately, and debt ceilings can be adjusted so that a potential oracle manipulation would not be profitable.
Proof-of-Liquidity alleviates Liquidity Risk and Oracle Risk
