The upside from having more aggressive collateral factors (CFs) seems well understood in terms of increasing capital efficiency, which brings in elastic demand. The downside risks are well documented, but it doesn’t hurt to review them from first principles. Imagine a lot of this will be familiar to DeFi lending veterans but the discussion gets deeper quickly so let’s start from the basics.

Compound is an overcollateralized lending protocol, so a requirement for opening a loan is that the value of the collateral posted exceeds the value of the borrow taken out of the protocol. If this were not the case, an adversarial actor could profit by borrowing all the assets with no intention of paying back the loans. With no real recourse against anonymous attackers or trust measures like a widely used onchain analogue of a credit score, the default assumption is that any shortfall between debt and collateral will be a loss fully borne by the protocol. This is commonly referred to as insolvency risk.

In order to protect against insolvency risk, the protocol incentivizes external actors, known as liquidators, to reduce the size of the balance sheet by purchasing collateral via debt repayment at a discount to the exchange rate. When collateralization has dropped sufficiently to render a loan liquidatable, anyone can call the smart contract to execute the liquidation.

If liquidators always stepped in then there would never be any insolvencies. While there can be technical difficulties such as mempool congestion or market conditions where a loan becomes underwater in a single oracle update, the primary reason for liquidators to not act is simply that it is unprofitable for them.

Liquidators have several costs including

• execution costs

  • often slippage from atomically arbitraging using a DEX

  • urgency to exit a position that was taken over because it has substantially dropped in value

• network costs

  • gas

  • MEV required to land the transaction

• labor costs

  • is the expected payout worth the dev cycles

• opportunity cost

  • e.g. if Aave is paying more prioritize liquidating there first

  • if capital is tied up for awhile is their higher ROI elsewhere

If their share of the liquidation proceeds is insufficient to cover these costs, a liquidator is content to do nothing as the debt becomes insolvent.

In a Compound III liquidation, the collateral and debt of a loan are absorbed onto the protocol balance sheet, with the debt covered from the reserves. The amount of the borrow asset owed out to the user is their collateral value sans the liquidation penalty (LP). As such, we can derive the following relationship

$CF \leq LF \leq 1 - LP$

where LF refers to the liquidation factor, the left hand side of the inequality is set to prevent opening loans that are immediately liquidatable and the right hand side is set to prevent absorptions that immediately lead to insolvent debt.

Let us define the insolvency buffer (IB) as the maximum % the collateral price can drop relative to the debt between absorption and sale before Compound III takes a loss. This was previously derived by Gauntlet as

$IB = 1 - \displaystyle\frac{1 - LP}{1 - LP \cdot SFPF}$

where $SFPF$ is the store front price factor.

When $SFPF = 0$, $IB = LP$ and when $SFPF = 1$, $IB = 0$ and for all other cases the equation can be rewritten as

$IB = \displaystyle \frac{1 - SFPF}{SFPF} \bigg[ \frac{1}{1 - SFPF \cdot LP} -1 \bigg]$

which is an increasing function in $LP$ over $[0, 1]$.

Thus, raising CFs lowers the maximum LP for an asset, which in turn reduces both the insolvency buffer and the payment for a liquidator to take over loans before they become underwater. Outside of the rare case where LPs are set too high to the point where lowering them mitigates insolvencies caused by cascading liquidations, this leads to an increase in insolvency risk.

As repeated ad nauseum, the primary risk to a lending protocol are insolvencies where losses occur on overcollateralized loans when the borrow exceeds the value of the collateral. While infrequent, these can happen due to market events (such as depegs) or economic exploits (like an oracle price manipulation) and, in some cases act, as a death knell for a protocol, as seen in the example of Mango Markets below.

Even when the monetary loss of insolvencies themselves are not that significant, they can lead to a crisis of faith in the protocol. In a space filled with memecoin casinos, lending is supposed to be a comparatively safe source of yield so any loss on principal could trigger withdrawals, which could escalate into a bank run.

In mid 2022, Aave experienced a 50%+ drawdown in TVL following the UST and stETH depegs, outpacing the 30% drop in ETH over the period. This disparity is indicative of substantial amounts of withdrawals and loan closures.

While setting CFs too low could also lead to users withdrawing to seek better capital efficiency elsewhere, the rate of TVL loss tends to be much more gradual, with inelastic demand staying put.

Raising CFs constrains the maximum LP, which reduces both the insolvency buffer and the incentive liquidators demand to cover their costs. For assets where LPs are already set to moderate or low levels, this directly leads to an increase in insolvency risk. In addition to the initial monetary loss, the risk can be further exacerbated by a bank run and brand damage.

The upside from having more aggressive collateral factors (CFs) seems well understood in terms of increasing capital efficiency, which brings in elastic demand. The downside risks are well documented, but it doesn’t hurt to review them from first principles. Imagine a lot of this will be familiar to DeFi lending veterans but the discussion gets deeper quickly so let’s start from the basics.

Compound is an overcollateralized lending protocol, so a requirement for opening a loan is that the value of the collateral posted exceeds the value of the borrow taken out of the protocol. If this were not the case, an adversarial actor could profit by borrowing all the assets with no intention of paying back the loans. With no real recourse against anonymous attackers or trust measures like a widely used onchain analogue of a credit score, the default assumption is that any shortfall between debt and collateral will be a loss fully borne by the protocol. This is commonly referred to as insolvency risk.

In order to protect against insolvency risk, the protocol incentivizes external actors, known as liquidators, to reduce the size of the balance sheet by purchasing collateral via debt repayment at a discount to the exchange rate. When collateralization has dropped sufficiently to render a loan liquidatable, anyone can call the smart contract to execute the liquidation.

If liquidators always stepped in then there would never be any insolvencies. While there can be technical difficulties such as mempool congestion or market conditions where a loan becomes underwater in a single oracle update, the primary reason for liquidators to not act is simply that it is unprofitable for them.

Liquidators have several costs including

• execution costs

  • often slippage from atomically arbitraging using a DEX

  • urgency to exit a position that was taken over because it has substantially dropped in value

• network costs

  • gas

  • MEV required to land the transaction

• labor costs

  • is the expected payout worth the dev cycles

• opportunity cost

  • e.g. if Aave is paying more prioritize liquidating there first

  • if capital is tied up for awhile is their higher ROI elsewhere

If their share of the liquidation proceeds is insufficient to cover these costs, a liquidator is content to do nothing as the debt becomes insolvent.

In a Compound III liquidation, the collateral and debt of a loan are absorbed onto the protocol balance sheet, with the debt covered from the reserves. The amount of the borrow asset owed out to the user is their collateral value sans the liquidation penalty (LP). As such, we can derive the following relationship

$CF \leq LF \leq 1 - LP$

where LF refers to the liquidation factor, the left hand side of the inequality is set to prevent opening loans that are immediately liquidatable and the right hand side is set to prevent absorptions that immediately lead to insolvent debt.

Let us define the insolvency buffer (IB) as the maximum % the collateral price can drop relative to the debt between absorption and sale before Compound III takes a loss. This was previously derived by Gauntlet as

$IB = 1 - \displaystyle\frac{1 - LP}{1 - LP \cdot SFPF}$

where $SFPF$ is the store front price factor.

When $SFPF = 0$, $IB = LP$ and when $SFPF = 1$, $IB = 0$ and for all other cases the equation can be rewritten as

$IB = \displaystyle \frac{1 - SFPF}{SFPF} \bigg[ \frac{1}{1 - SFPF \cdot LP} -1 \bigg]$

which is an increasing function in $LP$ over $[0, 1]$.

Thus, raising CFs lowers the maximum LP for an asset, which in turn reduces both the insolvency buffer and the payment for a liquidator to take over loans before they become underwater. Outside of the rare case where LPs are set too high to the point where lowering them mitigates insolvencies caused by cascading liquidations, this leads to an increase in insolvency risk.

As repeated ad nauseum, the primary risk to a lending protocol are insolvencies where losses occur on overcollateralized loans when the borrow exceeds the value of the collateral. While infrequent, these can happen due to market events (such as depegs) or economic exploits (like an oracle price manipulation) and, in some cases act, as a death knell for a protocol, as seen in the example of Mango Markets below.

Even when the monetary loss of insolvencies themselves are not that significant, they can lead to a crisis of faith in the protocol. In a space filled with memecoin casinos, lending is supposed to be a comparatively safe source of yield so any loss on principal could trigger withdrawals, which could escalate into a bank run.

In mid 2022, Aave experienced a 50%+ drawdown in TVL following the UST and stETH depegs, outpacing the 30% drop in ETH over the period. This disparity is indicative of substantial amounts of withdrawals and loan closures.

While setting CFs too low could also lead to users withdrawing to seek better capital efficiency elsewhere, the rate of TVL loss tends to be much more gradual, with inelastic demand staying put.

Raising CFs constrains the maximum LP, which reduces both the insolvency buffer and the incentive liquidators demand to cover their costs. For assets where LPs are already set to moderate or low levels, this directly leads to an increase in insolvency risk. In addition to the initial monetary loss, the risk can be further exacerbated by a bank run and brand damage.