Risks
It’s important to make a distinction between two types of risks, that occur due to market volatility:
- Collateral value risk
- Impermanent loss risk
The second type of risk is extensively covered by many practitioners of DeFi liquidity contracts and very often it is more of an accounting (missed profits) than actual loss to a liquidity provider. Nevertheless, it can pose a real problem in the case of extreme exchange rate movements. In practice though, the more important risk will be the collateral value one. It occurs when the value of the contract expressed in USD terms is not enough to cover the borrowed funds. These cases generally occur when the prices of assets change in such a way that the total value of the Farm expressed in a borrowed asset no longer covers it.
Asset borrowed by the Farmer | Asset Price Change | Impact on the Farmer |
Tezos | Increases relative to BTC | Negative |
Tezos | Decreases relative to BTC | Positive |
Bitcoin | Increases relative to XTZ | Negative |
Bitcoin | Decreases relative to XTZ | Positive |
TradFi analogy: imagine a scenario where one borrows in JPY to invest in USD assets. Naturally, the borrower benefits from JPY weakening relative to USD (he has less to repay in dollar terms). Yen getting stronger to USD is then a negative event as you have less invested assets in Yen terms to cover the debt.
In our case a hypothetical tezos maximalist Farmer might borrow in BTC if he believes that Tezos will become stronger relative to BTC and the value of the Farm expressed in BTC terms will further grow, providing a cushion for his debt. However, if the BTC becomes relatively more expensive to XTZ (whether because Bitcoin price jumps, Tezos price decreases, or both happen in USD terms) Farm value converted to BTC can become dangerously low and the Farmer can get liquidated, losing all of his funds.
As we have mentioned liquidation above it is important to underscore that it serves as the primary risk mitigation tool for Kord.Fi. What do we achieve by implementing the liquidation process? Well:
• Proper risk-sharing. Liquidation makes Farmers the default first party to eat capital losses on adverse exchange rate movements thanks to the fact they receive nothing in case of Firm unwinding. This is a healthy arrangement as Farmers are compensated for their risks by much higher APYs than Lenders.
• Healthy incentives. Knowledge of the fact that you can get liquidated by any third party when your collateral value falls below borrowed sum provides a discipline and stimulus to choose manageable and tolerable levels of risk for Farmers, preventing leverage overextension
• Financial stability. Sometimes market volatility might be too extreme for third-party arbitrageurs to step in and liquidate Farms in time and they may go underwater and be liquidated at a loss even to the Lenders. Other times our mechanism will work perfectly fine and the excess funds (difference between collateral and borrowing values) will partially go to Lenders. This allows us to generate additional profits for Lenders in “good” times to cover their losses in “bad”, smoothing their overall return profile and further decreasing the risks.
