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Risk Methodology

Risk methodology refers to the set of parameters and calculations used by the Mars protocol to determine the risk associated with different assets, protocols, and user positions, in order to minimize the risk of bad debt and ensure orderly and profitable liquidations. The process involves several key steps:

1. Protocol Integration​

The first step is to determine whether a specific protocol is suitable for use as collateral. This involves considering two categories of risk, i.e, Technical Risk and Centralization Risk:

Technical Risk​

It involves: Smart contract risk, audit track record, critical vulnerabilities, and bug bounty programs

  • Smart Contract Risk: Analyzing the underlying smart contract of the asset for vulnerabilities that could impact its value or functionality.
  • Audit Track Record: Regular audits by reputable security firms provide assurance of the smart contracts' integrity. The results of these audits should be made public to foster trust and transparency.

Centralization Risk​

Assessing the degree of control or centralization associated with the asset. Highly centralized assets pose greater risks due to potential manipulation or mismanagement.

2. Determining Max LTV and Liquidation LTV​

Just like protocol integration, the asset and LP tokens also go through a critical examination of associated technical risk and centralization risk. However, as per the Mars Risk Framework two additional vectors are taken into account before listing them, i.e., oracle and bridging risk.

If a protocol passes the eligibility criteria, the next step is to determine the appropriate Max LTV and Liquidation LTV based on factors like centralization, asset volatility, smart contract security, bridging risk, and liquidation thresholds.

Max LTV (Loan-to-Value Ratio)​

The Max LTV is the maximum percentage of a collateral asset's value that can be borrowed. It's a crucial parameter in determining the risk associated with a loan. For instance, if an asset is valued at $100 and the Max LTV is 70%, the maximum loanable amount is $70.

Liquidation LTV​

The Liquidation LTV is the threshold at which a borrower's position is automatically liquidated to protect the lender. It's typically set below the Max LTV to provide a safety margin. However, on Mars it has been set above the Max LTV, For instance, if the Max LTV is 74%, the Liquidation LTV could be 75% for an asset, and the position will be liquidated when the loan-to-value ratio reaches 75%. The difference between the Max LTV and Liquidation LTV creates a buffer zone, allowing Liquidators to liquidate the asset to maintain profitability and avoid potential losses.

Health Factor​

The Health Factor is a real-time measure of a borrower's position health. It's calculated by dividing the total value of collateral as per Liquidation LTV by the total debt. A health factor greater than 1 indicates a healthy position, while a value below 1 signals liquidation risk. For example, if a borrower has $150 worth of collateral as per Liquid LTV and owes $100, their health factor is 1.5. This indicates a relatively safe position. However, if the collateral value drops to $100 while the debt remains constant, the health factor becomes 1, indicating a liquidation risk.

3. Implementing Deposit Caps​

To further manage risk, Deposit Caps are imposed on individual assets. These are limits imposed on the amount of a specific asset that can be deposited into the protocol. These caps help mitigate systemic risks by preventing excessive concentration of a particular asset. Mars Protocol employs a sophisticated Deposit Cap Framework to determine deposit caps, considering factors such as:

  • a. On-Chain Liquidity: The amount of liquidity available for a specific asset on the blockchain.
  • b. Global Liquidity: The total liquidity across both centralized and decentralized exchanges.
  • c. Price Impact: The potential impact of large-scale liquidations on asset prices.

Calculation Methodology:​

MaxCap = min(MedianOnChainDepth_25pct_90d, 10 * Global Depth_2pct)

Where:

  • MedianOnChainDepth_25pct_90d: The median dollar cost required to move the on-chain price down by 25% over the past 90 days.
  • GlobalDepth_2pct: The total dollar liquidity required to move the price by -2% across major exchanges.

By setting deposit caps, the protocol can reduce the impact of a significant price decline in a single asset on the overall platform while deterring malicious actors from manipulating the protocol by artificially inflating asset prices. It also helps to maintain a diversified collateral pool, which can improve the protocol's resilience.

Overall Goal​

The risk methodology framework aims to balance risk and reward by carefully selecting eligible assets, setting appropriate risk parameters, and implementing deposit caps. The ultimate goal is to create a stable and sustainable lending platform while maximizing opportunities for borrowers and lenders. All these parameters and factors work in conjunction to manage risk effectively. A well-balanced combination of Max LTV, Liquidation LTV, Deposit Caps, and Health Factors is essential for the stability and sustainability of a lending protocol.

By following this structured approach, Mars Protocol aims to effectively manage risk and protect the interests of all participants.

Read More: Mars Risk Framework