Unveiling the Powerhouse: Minterest Solvency Engine

Liquidity is the lifeblood of DeFi money markets like Minterest. In such ecosystems, liquidations serve as a critical safety net, maintaining stability amidst volatile token markets. But not all liquidation systems are made equal—some are prone to misaligned incentives, leading to predatory behaviour against liquidity providers. Minterest aims to address this imbalance. In this article, we delve into the Solvency Engine, formerly known as the Liquidation Engine.

The Importance of Liquidations in DeFi

In DeFi money markets, borrowers must back their loans with collateral. Minterest requires that each borrowed dollar be overcollateralized, meaning you must put up more than a dollar’s worth of assets to borrow one dollar. This acts as a shield against market fluctuations but comes with risks for borrowers, who may face liquidation if their positions turn insolvent. Liquidation sells some (or all) of the borrowers collateral in order to bring their loan positions back above a healthy threshold. 

Liquidations are necessary, and designed to ensure the solvency of the protocol while maintaining safety for all liquidity providers.

How Liquidations Work

Platforms like Compound and AAVE lure third-party liquidators by providing them discounts. These liquidators purchase collateral at discounted rates to restore the protocol to solvency, usually around 10%. So the liquidator received USD $1.10 of collateral for every USD $1 of repaid borrow position.

The protocol’s role is also to define the rules of how liquidators may operate. Let’s take a closer look at the insolvency and overcollateralization first. As an example, if Bob lends 100 USDT, the protocol states that Bob may borrow up to 60 USD of BTC. That means, that if the borrowed BTC actually reaches 61 USD of value – the position is considered insolvent and subject to liquidation. But this position is still overcollateralized – the protocol has enough USDT to provide the 10% discount. So a liquidator will get 67.1 USDT for liquidating 61 USD of BTC position.

Third Party Liquidations can be Predatory

The landscape of liquidation systems within the money markets of decentralized finance (DeFi) is anything but uniform. At the heart of this complexity are conflicting interests between two critical actors:

• • 1. Liquidity Providers: who supply the assets to the protocol.
• • 2. Liquidators: who ensure the protocol’s solvency by buying up collateral at critical times.

Protocols strive to offer appealing conditions to attract and keep liquidity providers. Simultaneously, they have to lure liquidators to offload this very liquidity in situations that could otherwise lead to insolvency. Striking a balance between these competing interests is tricky, and often results in misaligned incentives capable of spurring predatory actions by liquidators.

The Rules of Engagement for Liquidators

Typically, liquidation rules are straightforward. Liquidators are free to pick the loans and collateral assets they want to work with, particularly when multiple borrowed and supplied assets are involved. They also have the discretion to liquidate up to a specific percentage of an insolvent position, often capped at 50%. In the earlier example of Bob, a liquidator could opt to pay back just $30.50 in BTC and receive $33.55 in USDT as compensation.

Liquidators could take less

Here’s an important consideration: solvency can often be achieved without taking the full allowed cut. If a liquidator decides to take only a 30% cut instead of 50%, the borrower actually regains solvency while retaining more of their collateral. However, the profit-driven nature of liquidation often deters this lenient approach.

For instance:

Health Factor before liquidation = 60/61= 0.98 (The goal is to reach 1 or higher.)
Health Factor after liquidation of ~30% = 60-20/61-22= 1.02
Health Factor after liquidation of ~50% = 60-30.5/61-33.55= 1.075

Exploiting the System

On the other hand, some savvy liquidators may employ a different strategy altogether. They could repay just enough to push the borrower back above the solvency line but precariously so. The moment the borrower’s position dips back into insolvency, the liquidator swoops in to seize a full 50% of the remaining position, thereby maximising their profit.

The Perils of Toxic Debt

Toxic debt also poses an urgent problem in DeFi, stemming primarily from the failure to timely liquidate insolvent positions. This issue manifests in two major ways:

• • 1. Toxic Debt Accumulation: When insolvent loans aren’t promptly liquidated—either because they’re too small for liquidators to consider profitable or due to network congestion—they accumulate as toxic debt. This snowballs into multiple challenges: it siphons away governance rewards, complicates market governance, and generates “ghost profits,” wherein the protocol owes more to liquidity providers than it has on hand.
• • 2. Liquidity Risk: While most protocols maintain a buffer pool, it’s susceptible to depletion during market downturns or bank runs. This could lock users’ assets within the protocol, stifling liquidity.

Consider this scenario: Alice expects a 10% APY on her 1 ETH deposit. Bob borrows this 1 ETH and becomes insolvent. The protocol still owes Alice her 1.1 ETH, but if Bob fails to repay his loan, the system can’t fulfill Alice’s expected returns.

In a large-scale market, accumulated toxic debt can escalate into a ticking financial time bomb, wherein withdrawal demands surpass the total market liquidity.

By addressing these aspects effectively, protocols can avoid a multitude of systemic risks, ensuring a more secure and stable financial ecosystem.

This brings us to the question: Is there a better way to manage liquidations that would be more equitable for all parties involved? And that’s where Minterest’s Solvency Engine comes into play, as we shall see later.

The Minterest Approach: Automation and Precision in Liquidations

Minterest elevates the approach to liquidating insolvent loans with two key differentiators: automation and precision.

• No Discount Required: Unlike traditional DeFi platforms that offer liquidators a 10% discount, Minterest’s Solvency Engine eliminates the need for such incentives. The discount is minimized to cover only the costs of liquidation, effectively reducing the profitability threshold for liquidations.
• Automated Efficiency: An automated system swiftly handles each insolvent position, regardless of the profit margin. This level of efficiency is achievable because the system operates without competition. It systematically processes insolvencies one at a time, taking into account current gas prices for optimal transaction execution.
• Precision in Calculations: The Solvency Engine employs a metric known as the “Redemption Rate” to pinpoint the exact loan value that needs to be repaid for user solvency. This ensures that liquidations are neither excessive nor repetitive. While the system does strategise for the most cost-effective transaction, focusing on gas costs and decentralised exchange (DEX) slippages, these calculations are strictly limited to within the defined Redemption Rate to preserve users’ best interests.

How the Solvency Engine Functions

The Solvency Engine operates through a combination of off-chain services and on-chain smart contracts, utilising flash loans to facilitate its processes. Here’s a snapshot of its inner workings:

• Tracking and Monitoring: A specialised service, known as the Borrowers Tracker, continually monitors all borrowers in the protocol for solvency, using real-time on-chain price data from Chainlink oracles.
• Redemption Rate Calculation: When an insolvent position is identified, another service jumps into action to calculate the precise “Redemption Rate” needed to restore solvency.
• Asset Optimization: This service also evaluates the borrower’s positions, generating a list of potential liquidation options within the defined Redemption Rate. It then calculates which assets and how much of each should be liquidated.
• Cost and Route Analysis: Leveraging the Uniswap router, the service identifies the most cost-effective liquidation paths, accounting for gas fees and exchange slippages.
• Transaction Formation: Upon confirming that a liquidation would be profitable, a transaction is crafted, signed, and dispatched to the blockchain network.

The executed transaction takes a flash loan to repay borrowed assets, seizes the collateral, swaps it to pay back the flash loan, and then funnels any remaining liquidity back into the protocol’s reserves.

By automating these intricate processes, the Solvency Engine ensures efficient, profitable, and fair liquidations, fortifying the protocol’s overall health.

Closing

The Minterest Solvency Engine emerges as a groundbreaking innovation in the decentralised finance sector, offering a comprehensive and automated approach to tackle the persistent issue of insolvent loan liquidation. By placing a premium on precision, efficiency, and automated solutions, the engine not only minimises the risk of toxic debt but also maximises the benefits for its users.

Its key advantage lies in its calculated frugality, eschewing the need for substantial discounts commonly used to entice third-party liquidators. The result is a more cost-effective liquidation process that favours the interests of the protocol and its users alike.

As Minterest continues to evolve, adopting the latest in smart contract and blockchain technologies, it sets the standard for what a secure and resilient DeFi ecosystem can look like. It offers a glimpse of a more stable and equitable financial future—a future that promises greater security and opportunity for everyone involved.

13, September 2023