Breakdown of Liquidation Incentive parameter utility and methodology
The liquidation incentive parameter determines the amount of additional collateral given to liquidators as an incentive to perform liquidations and keep the protocol solvent.
The liquidation incentive is equivalent to 10% of an underwater accounts' outstanding borrow, of which 30% returns to the protocol reserves.
The parameter is set globally for the protocol. In other words, all markets bear the same liquidation incentive setting.
In order for a liquidation to be profitable for a liquidator, the incentive must cover for the following liquidation costs:
Oracle vs market price skew for both collateral and debt currency
Slippage to sell the collateral currency and buy the debt currency.
Gas fees (swaps + liquidation)
In order to validate the robustness of the liquidation incentive our methodology relies on backtesting the profitability of simulated liquidations given historical market conditions.
More specifically, we backtest the block per block profitability of liquidating a given amount of a collateral asset. Our backtesting simulation will look at historical oracle price skews, slippage, and gas costs.
Based on our backtesting simulation, we will assess the longest time it would have taken for a liquidator to profitably execute a liquidation of a given trade size. This worst time to liquidation metric will allow us to measure the robustness of liquidation discounts.
The liquidation discount 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.