On a recent Governance & Risk call some concerns were raised about Liquidations 2.0 parameters chosen which in effect has expected auction duration of approximately 40 minutes. This is based on parameters proposed by us for LINK-A and YFI-A.
We have talked about trade-offs of long versus short auction duration in our initial LINK-A analysis. We also noted that we prefer longer duration than the one recommended by Gauntlet, which was 16 minutes.
To not go too much into details again, we made an analysis that shows what kind of losses Maker or Vaults can expect if bids start coming in late due to network congestion or any other reasons. Or in other words, what could be the loss for Maker or Vaults if keepers start bidding below market prices according to the price curve selected.
First, see again the price curve that is based on parameters proposed:
You can see that the price approaches 100% of the OSM price at around 40 minutes, when we would on average expect the bidding process to start. This is of course based on assumption that the market price is flat between the last OSM price taken and the 40 minutes time frame. If price falls additionally in this time frame, expected bid time is longer than 40 minutes, if price rebounds, expected bid is shorter than 40 minutes.
Also note that after the price from the price curve reaches 52% of OSM price (defined by ‘cusp’ set at 0.4), bids are no longer possible and auction can be redone by using the new OSM price.
What happens if no one bids after 40 minutes, but only after 50 minutes or even later? We made a simulation below that shows how this affects Maker and Vaults.
Source: own calculations
You will notice that lower collateralized vaults carry greater risks for loss, both for Maker as for Vaults. Maker would start seeing losses on average if no one bids in the first 80-100 minutes. This is true for lower collateralized vaults, whereas for 175% liquidation ratio vaults, about 2 hours without bids could pass before Maker starts having losses.
Again, this assumes market prices are stable which is not something we can expect. If market prices fall additionally, the loss associated with late bidding can be even more severe, but presumably bids in such case will have less delay since the expected auction duration gets longer (we define late as time delay from the point in time bid is expected to occur due to market opportunity). This simulation also assumes vaults get liquidated exactly at their liquidation ratio, whereas in reality they get liquidated below liquidation ratio based on OSM price, which again leads to greater loss.
Source: own calculations
Late bids are much more problematic for Vault owners who can lose a larger share of their overcollateral value if bids are low. You can see that almost half of overcollateral for 130% LR vaults is already lost initially due to 13% penalty fee. If the bid comes only about 20 minutes late after the expected 40 minutes duration, all the overcollateral value is lost for such a vault. For higher liquidation ratio vaults (i.e. 175%), about 1 hour late bids erase all of the vault owners’ value.
What does all of this tell us? If we are concerned about too-short auction durations where bids might be delayed for many minutes or even up to an hour, we are mostly concerned about the value that might be lost by vault owners, since Maker is pretty well hedged in that time frame.
Now, if we are to make auctions longer because of this concern, we start increasing market risk as collateral market prices might be deteriorating every passing minute. In other words, even if we don’t have delay on bids and they are perfect to match market price in let’s say 80 minutes, the market price could already move downward additionally. Note that under current liquidation system vault owners are already pretty heavily exposed to market price risk since auction duration takes 4 hours.
Therefore we have a trade-off where 1) we either believe 40 minutes time frame is good enough to attract enough bidders and we minimized market risk, or 2) we think 40 minutes time frame is too short leading to delayed bids and in order to minimize this risk we extend auction duration and simultaneously increase market risk.
It is hard to make this decision on a quantitative basis because so many different factors are at play and the most relevant one is network congestion under stressed conditions leading to delayed bids which is hard to predict. Any kind of feedback by the community would be appreciated here, especially since we are to propose parameters for ETH and WBTC vaults types where much larger value is at stake.
Here we also want to note that we have one other parameter at hand that mitigates losses associated with delayed bids. It’s called
ilk.hole which limits the amount of pending liquidations per vault type. If we lower the value for this parameter, the losses simulated above can be lowered in nominal amounts, but we again start increasing market risks as vaults could get liquidated later at lower collateralization ratios.