Proposal: Increase Liquidation Fee from 5% to 8%
Brief Description: The increase of protocol fees to 20% has logically prompted a corresponding vote and implementation of a 5% liquidation fee for undercollateralized loans. However, this number is still relatively low compared to other protocols and the standard across the DeFi landscape. An increase from 5% to 8% will boost participation in Lenfi’s open debt management system and increase its efficiency and robustness.
- Approve
- Disapprove
- Abstain
Problem
The increase in protocol fees from 2% to 20% has significantly impacted the availability of collateral post-liquidation. With a higher protocol fee, the remaining collateral after settling the debt (loan + accrued interest) reduces the potential profit liquidators may make from participating in Lenfi’s debt management system. With the growing use of the platform, it’s crucial to adjust the liquidation fee to maintain the incentive for liquidators to manage bad debt effectively.
Example:
- Collateral: 10,000 ADA
- Loan: 3,600 ADA
- Interests Accrued at Liquidation: 1,440 ADA (40% of the loan, representing a worst-case scenario over one year)
Previous Calculation with 2% Protocol Fee:
- Remaining Collateral: 10,000 - (3,600 + 1,440 + 2% * 1,440) = 4,931.2 ADA
- Liquidator Fee (2.5%): 2.5% * 4,931.2 = 123.28 ADA
Current Calculation with 20% Protocol Fee and 5% Liquidation Fee:
- Remaining Collateral: 10,000 - (3,600 + 1,440 + 20% * 1,440) = 4,672 ADA
- Liquidator Fee (5%): 5% * 4,672 = 233.6 ADA
Analysis with 8% Liquidation Fee:
- Liquidator Fee (8%): 8% * 4,672 = 373.76 ADA
The primary issue is that a lower liquidation fee introduces a high risk of bad debt during cascading liquidation.
With a liquidation fee of 5%, we could assume that the lower HF when the loan is liquidated is ~0.475. If HF falls below that, no one will make a profitable liquidation.
With a liquidation fee of 10%, liquidation profitability decreases to 0.45.
The issue is if we fall into bad debt and the asset never recovers - the loan will never be repaid.
P.S. This was not a possible issue until many users started opening loan positions collateralized with LENFI, SNEK, and IAG.
Solution
To ensure that liquidators are incentivized to handle liquidations effectively, even with the increased protocol fees, we propose to increase the liquidation fee from 5% to 8%. This adjustment aims to:
- Compensate for the decrease in the liquidator’s potential reward due to higher protocol fees.
- Maintain or increase the incentive for liquidators to act on undercollateralized positions, especially in scenarios where:
- The interest accrued represents a significant portion of the loan value (up to 38% after one year, aligning with the example from Mantas’ proposal for a 38% APR at 80% Utilization Rate).
- The loan is backed by assets with the lowest Liquidation Threshold (LT) of 1.3, which provides the smallest margin after liquidation.
New Liquidation Fee Calculation:
Given the equation for determining the new liquidation fee (x) in response to a 20% protocol fee:
x(HF⋅LT−1+(HF⋅LT−1.2)α)=0.025(HF⋅LT−1+(HF⋅LT−1.02)α)
Where:
- HF is the Health Factor at liquidation (set at 0.85 for LT = 1.3 in this proposal).
- LT is the Liquidation Threshold (1.3 in this scenario).
- Alpha (α) represents the percentage of accrued interest (38% in the worst-case scenario).
By solving for x when α = 0.38 and HF = 0.85, we find that setting x at 8% ensures that the liquidator’s compensation remains at least equivalent to the previous rate when considering the worst-case scenarios for accrued interest and liquidation thresholds.
Conclusion
Increasing the liquidation fee to 8% will maintain the balance between protocol sustainability through higher fee collection and the motivation for liquidators to engage in the liquidation process, ensuring the platform’s health and operational efficiency.