The smart contracts team has added a new section to the technical summary entitled UPDATE: liquidation Incentive Mechanism. I’ve included the text here for further review and discussion:
UPDATE: Liquidation Incentive Mechanism
After discussion in the above section (“An Open Question”), it was decided that an incentive mechanism should be added for liquidators. The final chosen form for the incentive was, on a per-collateral type basis, a constant amount of DAI plus an amount of DAI that scales linearly with the amount of debt associated with the liquidation. Either contribution can be set to zero. The reasoning behind these choices is as follows:
- The reward is set per-collateral to give maximum flexibility to include not just per-collateral risk parameters like
mat (collateralization ratio) and
chop (liquidation penalty) in its setting, but also to allow for unique market conditions that might only apply to one or a few collateral types.
- The component of the reward that increases linearly with the total Vault debt is intended to be used to reward liquidators for reducing risk to the system, as risk itself scales with the size of undercollateralized Vaults—a Vault that is twice as big as another represents twice the risk of bad debt accrual. Or viewed another way, liquidating two vaults of size X represents the same risk reduction as liquidating one Vault of size 2X—thus the reward to a liquidator ought to be similar. Further, the system can afford to pay more for larger liquidations, because the liquidation penalty is also proportional to the amount of debt outstanding for a given Vault.
- The constant component of the reward can be used to cover gas costs (which are per-Vault for liquidators) or to allow MKR holders to effectively pay Keepers to clear small Vaults that would otherwise not be attractive for liquidation.
These parameters must be set extremely carefully, lest it be possible to exploit the system by “farming” liquidation rewards (e.g. creating Vaults with the intention of liquidating them and profiting from the too-high rewards). Generally, the liquidation reward should remain less than the liquidation penalty by some margin of safety, at least to ensure the system is not accruing a deficit from liquidations. Liquidators should also be made aware of this feature, lest they be unable to extract the DAI they are awarded due to liquidating via a custom contract.