Breakdown of Collateral Factor parameter utility and methodology
The collateral factor determines the amount of debt that can be minted for every unit of a given collateral asset.
The most conservative possible setting would be 0 (users can’t use the asset as collateral), and the most aggressive possible setting would be 1 (users can borrow 100% of the value of this asset).
Moonwell is an over-collateralized lending protocol, meaning all borrow positions need to be backed by more collateral than debt. In other words, in order for the system to remain solvent, accumulation of bad debt must be avoided.
Setting a collateral factor of 100% is theoretically not possible, because in the advent of a liquidation, it would not be possible for the liquidator to close the violator’s position entirely using seized collateral.
The collateral factor ensures that liquidations can be conducted profitably within a very high level of confidence.
Measuring the probability of accumulating bad debt is not an exact science since it relies on predicting future market conditions (liquidity, oracle price skew, volatility).
Our approach to set collateral factors goes hand in hand with our methodology for setting the liquidation discount.
In order to validate the robustness of collateral factors, our methodology looks at historical maximum drawdowns over a given period of time. The selected period of time has to be larger than the worst time to liquidation metric we computed when validating liquidation discounts.
Collateral factors should be set to a level that, given the worst historical downturn events, would have allowed a position of a determined worst case size to be liquidated profitably within a specified time limit.
The worst case trade size can be determined using the current largest borrow positions. For example, a case where the top 5 debt positions become liquidatable could be considered as the worst case trade size.
The liquidation time limit can be set to a fixed value of 60 minutes. The collateral factor will need to be able to at least withstand the historical max drawdown for this time period and also cover for the liquidation discount.