NFT Liquidation Shortfall Study and Protocol Risk

In this paper, we look to check the robustness of borrower and protocol protections within our collateralized lending offering.

A user deposits Non-Fungible Tokens (ERC-721) and/or Fungible ERC-20 tokens as collateral in order to borrow other ERC-20 tokens. The available Loan-to-Value ratios and various definitions can be found on our asset risk page.

The loan remains valid as long as the value of total collateral remains above the Liquidation Threshold as calculated by:

Liquidation Thresholdi Collateral in ETHFloorTWAPLiquidation \ Threshold_i \ * \sum Collateral \ in \ ETH \leq Floor_{TWAP}

Executive Summary

Our study shows that the existing mechanism for pricing and liquidating ERC-721-collateralized loans subjects the Protocol and Liquidity Providers to minor Loss given LiquidationLoss \ given \ Liquidation. We have intentionally applied a smoothing factor to the Floor price in order to minimize the risk of unwanted loan liquidation—providing a better user experience to Borrowers. Notably, sharp market volatility in NFT prices and broader crypto tokens could forceLoss given LiquidationLoss \ given \ Liquidation given Liquidation across a small minority NFT collections in our collateralized borrowing system.

Our conservative simulations show that our system is stable in ETH and USD terms with low risk of Loss given LiquidationLoss \ given \ Liquidation​.

Liquidation and risks to the protocol and borrower

By definition ERC-721 tokens are non-fungible, they trade with lower liquidity relative to ERC-20’s. When used as collateral for loans in ERC-20 tokens, liquidation of these NFT’s could result with insufficient proceeds to cover the total loan value. Clearly we set low maximum Loan to Value (LTVLTV) ratios to account for said risk.

In order to minimize the volatility of liquidation triggers and prevent undue liquidations, we likewise set a liquidation trigger threshold short of full LTVLTVto also cover any potential shortfall in the process of liquidation.

To calculate maximum risk to the protocol we observe historical volatility in NFT collection floor prices and potential volatility as well as an additional margin for liquidation risk.

  • Assume a user has borrowed the full LTV available given posted collateral valued at the Floor Price of the NFT collection. Here

MaxLTV=iLTVi Collaterali in ETHMaxLTV = \sum_{\substack{i}} LTV_i \ * Collateral_i \ in \ ETH

For the purposes of this study we will assume the CollateralCollateral is given by the value of the Non-Fungible Token in ETH terms and no further ERC20 tokens are provided as collateral. Further we assume that the PricejPrice_j is equal to the FloorMaxFloor_{Max} as measured by the Maximum FloorTWAPFloor_{TWAP} of the preceding 10 days.

FloorTWAP=jFloorjTjjTjFloor_{{TWAP}} = \frac{\sum_{\substack{j}}Floor_{j}T_{j}}{\sum_{\substack{j}}T_{j}}
MaxLTV=LTVi  FloorTWAPMaxLTV = LTV_i \ * \ Floor_{TWAP}
  • Measure the historical frequency with which that FloorTWAPFloor_{TWAP} indicates that the collateral has fallen below the minimum Liquidation ThresholdLiquidation \ Threshold .

Liquidation occurs when the following conditions are met:

FloorTWAPMaxLTVLiquidation ThresholdFloor_{TWAP} \leq \frac{MaxLTV}{Liquidation \ Threshold}
  • Given the Liquidation trigger, observe the maximum Loss Given LiquidationLoss \ Given \ Liquidation according to the Floor Price of the given NFT collection at the time.

PriceLiquidation=FloorLiquidation(1Liquidation Penalty)Price_{Liquidation} = Floor_{Liquidation} *(1 - Liquidation \ Penalty)
Loss Given Liquidation=PriceLiquidationMaxLTVLoss \ Given \ Liquidation = Price_{Liquidation} - MaxLTV

The Protocol will see shortfall if the MaxLTVMaxLTV exceeds the total proceeds as noted by the PriceLiquidationPrice_{Liquidation}.

We use the above assumptions and complement this with real NFT sales data to simulate the frequency with which the Protocol may see Loss Given LiquidationLoss \ Given \ Liquidation. Given the average monthly volume of a given NFT collection, we assume a new MaxLTVMaxLTV loan is made with the frequency of an average sale.

For example, on-chain data shows CryptoPunks have sold 7,820 times through 2022-06-19, indicating that a sale occurs every 60 minutes. This is the frequency of the MaxLTVMaxLTV loan in our model.

The table below summarizes data for all collections, while charts can be viewed for individual collections in the images which follow.

ETH Losses Given Liquidation

For this study we assume all NFT-collateralized borrowing is in ETH which itself is the quote currency for the NFT's themselves.

With the notable exception of Azuki, our model and liquidation mechanism provide protection against loan liquidation and Loss Given LiquidationLoss \ Given \ Liquidation.

The Loss Given LiquidationLoss \ Given \ Liquidationin Azuki will be the subject of further iteration on our Liquidation mechanism.​

Collection
Liquidation at Raw Floor Price
Liquidation at TWAP Floor Price
Total ETH Loss Given Liquidation

Azuki

1.7%

1.7%

-2,450

Bored Ape Yacht Club

0.0%

0.0%

0

CryptoPunks

0.0%

0.0%

0

Doodles

0.0%

0.0%

0

Mutant Ape Yacht Club

0.0%

0.0%

0

Bored Ape Kennel Club

0.0%

0.0%

0

VeeFriends

0.0%

0.0%

0

CloneX

0.0%

0.0%

0

USD Losses Given Liquidation

When we assume the Borrower uses their NFT's as collateral to borrow in USD terms the results show greater risk of Liquidation and a higher risk of Loss Given LiquidationLoss \ Given \ Liquidation ​. With the clear exception of Azuki, however, our model and liquidation mechanism provides ample risk controls for our NFT lending Protocol.

Collections
Liquidation at Raw Floor Price
Liquidation at TWAP Floor Price
Total USD Loss Given Liquidation

Azuki

5.97%

5.60%

-$26,202,597

Bored Ape Yacht Club

0.01%

0.00%

$0

CryptoPunks

0.00%

0.00%

$0

Doodles

1.06%

0.87%

$0

Mutant Ape Yacht Club

0.52%

0.37%

$0

Bored Ape Kennel Club

0.02%

0.00%

$0

VeeFriends

0.00%

0.00%

$0

CloneX

0.66%

0.00%

$0

Study of Bored Ape Yacht Club

The Bored Ape Yacht Club has seen exceedingly rare liquidation triggers and ultimately none which would have, according to our assumptions, produced a Loss given LiquidationLoss \ given \ Liquidation.

FloorRaw\color{blue} Floor_{Raw} FloorTWAP\color{orange} Floor_{TWAP} Liquidation Threshold\color{purple} Liquidation \ Threshold MaxLTV\color{red} MaxLTV

Study of Azuki

The Azuki collection is the largest historical loser in the selected collections given the notable fall in FloorFloor and the ETHUSD price through early May.

FloorRaw\color{blue} Floor_{Raw} FloorTWAP\color{orange} Floor_{TWAP} Liquidation Threshold\color{purple} Liquidation \ Threshold MaxLTV\color{red} MaxLTV

Study of Doodles

The Doodles collection would not have produced Loss given LiquidationLoss \ given \ Liquidationdespite notable volatility in its floor price and the price of ETHUSD.

FloorRaw\color{blue} Floor_{Raw} FloorTWAP\color{orange} Floor_{TWAP} Liquidation Threshold\color{purple} Liquidation \ Threshold MaxLTV\color{red} MaxLTV

Study of Mutant Ape Yacht Club

The Mutant Ape Yacht Club shows a modest risk profile for borrowers and the Protocol.

FloorRaw\color{blue} Floor_{Raw} FloorTWAP\color{orange} Floor_{TWAP} Liquidation Threshold\color{purple} Liquidation \ Threshold MaxLTV\color{red} MaxLTV

Study of CryptoPunks

According to our Liquidation model, the CryptoPunks collection would not have produced a loan Liquidation throughout the nearly-year-long price history in our sample.

FloorRaw\color{blue} Floor_{Raw} FloorTWAP\color{orange} Floor_{TWAP} Liquidation Threshold\color{purple} Liquidation \ Threshold MaxLTV\color{red} MaxLTV

Study of VeeFriends

The VeeFriends collection has historically shown itself stable as the basis for borrowing USD-denominated coins against the collection's NFT's.

FloorRaw\color{blue} Floor_{Raw} FloorTWAP\color{orange} Floor_{TWAP} Liquidation Threshold\color{purple} Liquidation \ Threshold MaxLTV\color{red} MaxLTV

Study of Bored Ape Kennel Club

Although more volatile than the Bored Ape Yacht Club collection, the Bored Ape Kennel Club has historically shown itself as stable collateral against USD-denominated borrowing.

FloorRaw\color{blue} Floor_{Raw} FloorTWAP\color{orange} Floor_{TWAP} Liquidation Threshold\color{purple} Liquidation \ Threshold MaxLTV\color{red} MaxLTV

Study of CloneX

According to on-chain data, the CloneX collection has historically shown itself as stable collateral against USD-denominated borrowing.

FloorRaw\color{blue} Floor_{Raw} FloorTWAP\color{orange} Floor_{TWAP} Liquidation Threshold\color{purple} Liquidation \ Threshold MaxLTV\color{red} MaxLTV

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