Introduction
The following response has been prepared after a Request For Comment (RFC) on Partial Liquidations. It is not a critique of partial liquidations as a concept, but is instead intended to highlight areas of the Partial Liquidations [RFC] which may need further elaboration or refinement. The intention being to raise concerns as early as possible before development starts.
While the RFC frames liquidations as bad for the protocol and users, it should be noted that liquidations form a crucial part of protocol health. Any proposed change to the liquidation mechanism should be considered within the greater context of protocol health.
An overview of the liquidation mechanism has been provided on the forum before, while more recent and detailed explanations of the liquidation mechanism have been provided by Guantlet here and here. The main concerns identified are noted below.
1. Partial Liquidations and Target Reserves
The RFC does not consider the role of target reserves within a Comet and the critical role it plays within the liquidation process. For example, the suggestion to unite the absorption and collateral purchase within one function raises technical and economic concerns, as buying collateral (through the buyCollateral function) requires that the targetReserves of the particular Comet be below the protocol configured threshold. If there are enough reserves within the Comet Market, the collateral that is seized during an absorb is held by the Comet Market and can only be sold once the reserves have fallen sufficiently.
The proposed implementation aprears intent on removing this restriction for partial liquidations to allow liquidators to liquidate and purchase collateral at the same time. However, the practical effect would be that this economic balancing mechanism is removed from the Comet Market entirely, as partial liquidations are more likely to happen before full liquidations. Consequently, this fundamentally changes the economic design of the Comet Market.
2. Selective Collateral Seizure
This is the place to apply a rule: the liquidator should set the collateral to seize and the order of collaterals to get and use one collateral at a time.
The selective seizure of collateral introduces complexities which are not considered within the RFC. Allowing a liquidator to seize a specified collateral during a partial liquidation exposes the borrower to a griefing risk, where the liquidator is able to change the risk profile of a borrower’s position through seizing the less volatile collateral first.
For example, within the context of a collateral asset’s value falling a liquidator may continuously choose to seize those collaterals which are more stable. Each time a liquidator seizes the “stronger” collateral the user’s risk position deteriorates further and they are more likely to become eligible for partial liquidation again and eventually full liquidation.
3. Partial Liquidation Factor
The RFC proposes a new variable called the partial liquidation factor which defines the threshold for partial liquidations:
Allow partial liquidation to start earlier than full liquidation - implement a sub-liquidation factor (lower than the liquidation factor), which will be used to check if a user is eligible for the partial liquidation (partial liquidations will start on a lower HF than full liquidation).
Introduce a new threshold for assets - PLF, partial liquidation factor (collateral factor <= PLF <= liquidation factor). It will define a respective PLHF (partial liquidation health factor). Thus, HF <= PLHF <= LHF <= bad debt health factor
That gives an interval for the debt to fall (from PLHF to LHF) and be eligible for partial liquidation
Bound the liquidator’s discount to the Target HF / actual HF value, to have an increased discount for early partial liquidations
This means that, for the same position within the current Comet Market, a user will be eligible to be partially liquidated earlier. Frontloading the incentive for early partial liquidations as suggested means that users should expect to always be partially liquidated early. Consequently the penalty for liquidation may always be at it’s maximum, because the user is returned to a healthy position which may then become eligible for partial liquidations again.
Crucially, the implementation of such a partial liquidation threshold which is intended to take effect earlier than the current liquidation threshold requires greater overcollateralization for the same position in order to avoid partial liquidation and suffer a penalty. In other words it artificially inflates the collateral requirements for borrowers.
In addition to this, it should be noted that each time a user is partially liquidated their debt to the protocol is lowered, which means less interest is earned until the next time they reach a liquidation threshold or they increase their position again. Compared with taking the hit of a single liquidation, borrowers also stand to lose a greater portion of their net position if prices continue to decline beyond the LHF = 1 boundary point and repeated partial liquidations occur.
The partial liquidation factor adds more complexity to the Comet Market’s incentive design which must be carefully balanced so as to not deter borrowing.
4. Insufficient Modelling
The RFC helpfully provides a document used for modelling, which is useful for demonstrating the intended implementation in a simple scenario. However, no other historical data is used or models provided which demonstrate the effect of the partial liquidation mechanism versus the current system. Such a comparison, especially where historical market data is used and a clear benefit can be shown is crucial in designing an effective partial liquidation implementation which does not deter borrowers.
5. Liquidator Portfolio Size as a Participation Barrier
The RFC notes that partial liquidations may motivate liquidators with smaller portfolio sizes to participate in liquidations.
It encourages liquidators with low- and medium-sized portfolios to participate in liquidations
While greater participation is a positive, it should be noted that the arbitrage opportunities created by collateral purchasing within the Comet Market are accessible through the use of flashloans, significantly decreasing the barrier to entry. However, liquidation arbitrage has become a sophisticated endevour and some barriers such as research, development and the subsequent maintenance of searchers present greater barriers to participation at this time.
6. Mandatory Opt-In for Borrowers
The partial liquidation mechanism has tradeoffs for borrowers, granting more time to deposit additional margin at the expense of greater overcollateralization requirements. However, the proposed changes would affect any new or existing positions automatically, with no possibility of opting out.
Borrowers who are not aware of the update may experience unexpected partial liquidations, especially for existing positions that have been inactive for a period of time. Changes to the liquidation mechanism are delicate, and could erode the goodwill of the protocol, disincentivizing future borrowing.
Conclusion
The RFC is a good starting point for the discussion on partial liquidation solutions for Comet Markets and the Woof! team is commended for describing a possible implementation.
Any changes to the liquidation mechanism requires careful consideration of the economic and technical mechanisms which support protocol health. Rigorous research and modeling is also important to gauge the possible effects such a change may have on protocol health, participant incentives and interest earned.