Preventing Bad Debt

One of the primary points of consideration is preventing toxic liquidity, defined as liquidations that lower the health factor of the portfolio instead of improving it. As highlighted by the Curve Attack on Aave, static incentives pushed the portfolio into a toxic liquidity spiral that, with each subsequent liquidation, deteriorated the health of the portfolio as opposed to improving it, creating lousy debt. The solutions laid out by the Toxic Liquidation Spiral paper by Jakub Warmuz, Amit Chaudhary, and Daniele Pinna are two-fold (note that this assumes a traditional DeFi liquidation order book queue where liquidations bid for discounts on unhealthy collateral to bring it back to healthy levels by repaying parts of the loan):

1. Dynamic incentives

2. Dynamic Closing factor

Dynamic Incentives:

Dynamic Incentives ensure that liqudations can’t:

1. Make the position more unhealthy

2. Make the position healthier than the initial margin (except for Health Ratio < 1)

3. Can’t be more than x% * collateral discount

x% is defined by asset risk classification (the riskier, the higher the discount)

The point of dynamic is incentives to liquidate the portfolio in a way that prevents toxic liquidity - recall from above, this is not bad debt but a liquidation that deteriorates the health factor of the portfolio, which then typically leads to bad debt - insolvency. This equation can be written as

$(i) < (1/HealthRatio) -1$

Where (i) equals the collateral value of the loan amount repaid plus the premium of the liquidation incentive. As the Health Ratio approaches 1, the liquidation incentives diminish, which is by design, as there are still instances in which liquidation arb opportunities would exist to close this position, especially in volatile mean reverting markets. This equation can also be written as a non-negative number; see equation 7 in the Toxic Liquidation Spiral paper.

Additionally, the liquidation queue limits liquidators from making the position healthier than the initial margin. Combined with the above formula, this creates a band that liquidators must operate within, thus protecting the borrows from unethical liquidations.

Lastly, there is a liquidation fee cap that does not allow fees to go beyond x% of collateral. This is set by asset risk classification, with riskier assets being assigned a higher % discount cap than risky assets.

Dynamic Closing Factor:

Under this model, the amount of the user's unhealthy portfolio available for liquidation increases as it gets closer to a Health Ratio of 1, rising to a point at which the entire collateral is offered to liquidators. Therefore, the dynamic closing factor further incentivizes liquidators in times of stress to compensate for the diminishing dynamic incentives as the portfolio gets closer to bad debt (see equation 8 in the Toxic Liquidation Spiral paper).

In Corcodia’s case, the dynamic close can be set at a higher threshold, thereby closing out the entire portfolio before it reaches a Health Ratio of 1. This threshold is called the dynamic close, similar to margin sales in traditional capital markets. Note this threshold closeout variable is set by governance.

In summary, the use of both the Dynamic Closing Factor and Dynamic Incentives together allows Concordia to increase incentives for liquidators by increasing the amount of collateral available for liquidation in line with the riskiness of the distressed portfolios' Health Ratio, thereby further de-risking the protocol linearly with the risk it carries.