salon2/smartltv

[utterances-bot]

A Smart Contract Formula for LTV Ratio | OneTrueKirk

Ethereum, cryptoeconomics, governance

https://onetruekirk.github.io/salon2/smartltv.html

[jfarid27]

Very interesting. I ran this against the Merton credit risk formula, using the expected c=5 and some rough crypto assumptions (volatility 0.4, expected return=0). The formula itself with a liquidity/debt-cap ratio of around 10 actually yields a recommended LTV of 50%. Substituting this into the Merton model gives some default probabilities it actually aligns very well with intuition, where using an LTV of 50% gives default probability of the loan around 10% with reasonable parameters.

Some thoughts I have:

• The proof you wrote is a pretty telescope. It would have been nice to include the middle steps from just to help explain to the reader the proof.
• YMMV on the assumption that prices are lognormally distributed during liquidations. MEV attacks just skew that.
• I am highly suspect of liquidity depth. This is a topic discussed by multiple analysts in the field that liquidity depth and volatility is highly manipulated due to yield farming, which incentivizes liquidity thus suppressing volatility. I would have loved to see a mention there since those metrics are very subjective to analysis. It might be interesting to study this model where liquidity and volatility can exhibit jump discontinuities. My only concern is if this is done, no one would lend in crypto.

[pre-vert]

The strategy of automating risk management in lending is interesting. My question is, suppose volatility is increasing and max LTV is automatically decreasing. In this case, some positions become undercollateralized and the right move is to liquidate them on the fly. But, then, this leads to bad UX for borrowers.

[OneTrueKirk]

While it's true that liquidations during periods of increased volatility are bad for borrowers, this can be mitigated by allowing borrowers to partially unwind to reach the new target collateral ratio, as well as non-punitive, auction based liquidation where the borrower is able to participate themselves to reduce costs to the theoretical minimum of the swap fee to unwind. With flash loans and a smart wallet, borrowers can automate their position management and mitigate the UX consequences of a strong liquidation policy.