Background
Gauntlet’s goal with initial asset listings is to ensure that insolvency and liquidity risks are minimized and that when liquidations occur, they can be done healthily with incentivized liquidators. To be unbiased, Gauntlet will not explicitly support any asset listing but instead provide risk recommendations for the community. Gauntlet will assess a given asset’s liquidity and other market characteristics to be added to the protocol.
Gauntlet will relay our findings to the EC and make parameter recommendations for Minimum Collateralization Ratio, Liquidation Ratio, Liquidation Penalty, Mini Limit, etc. For initial asset listings, the parameter recommendations are based on market and liquidity data. After 30 days of user positions developing on the protocol, Gauntlet will provide risk recommendations based on the actual usage data and market conditions using our risk models.
Summary
DOT is the cryptocurrency token associated with the Polkadot network, which is a blockchain platform designed to enable different blockchains to interoperate and share information. Polkadot aims to create a scalable and secure platform for decentralized applications (dApps) and services. DOT holders can lock up their tokens as collateral and participate in the network’s proof-of-stake (PoS) consensus mechanism. Stakers are rewarded with additional DOT tokens for helping to secure the network. In the context of a new asset listing, Gauntlet’s primary objective is to mitigate insolvency and liquidity risks while ensuring that liquidations, when necessary, are conducted in a healthy manner.
If the IST community votes to list DOT as an asset, Gauntlet presents the community with two options for risk parameters: Minimum Collateral Ratio, Liquidation Ratio, and Mint Limit. Option 1 adopts an LR approach with a higher Liquidation Ratio and a correspondingly higher Mint Limit. On the other hand, Option 2 features a lower Liquidation Ratio alongside a reduced Mint Limit. Both options empower the community by providing choices, allowing them to decide whether to prioritize a higher Liquidation Ratio or a higher Mint Limit. These choices aim to minimize risk exposure when listing an initial asset, ensuring a well-considered and secure launch process.
Option 1:
| Parameter | DOT |
|---|---|
| Minimum Collateral Ratio | 200% |
| Liquidation Ratio | 180% |
| Mint Limit | $200,000 |
Option 2:
| Parameter | DOT |
|---|---|
| Minimum Collateral Ratio | 230% |
| Liquidation Ratio | 210% |
| Mint Limit | $500,000 |
It’s important to note that if a protocol is required to increase the liquidation ratio to minimize risk, this action can result in a poor user experience. Therefore, this parameter should be lowered gradually over time as the market evolves and liquidation mechanisms are thoroughly tested.
General Recommendation
| Parameter | DOT |
|---|---|
| Interest Rate | 2.5% |
| Liquidation Penalty | 10% |
| Minting Fee | $0 |
| Minimum Initial Debt | $50 |
Analysis
What is DOT?
- DOT holders can lock up their tokens and participate in the network’s proof-of-stake (PoS) consensus mechanism. Stakers are rewarded with additional DOT tokens for helping to secure the network.
- DOT holders can bond their tokens to become validators or nominators in the network. Validators validate transactions and produce new blocks, while nominators select validators to support and share in their rewards.
- DOT token holders play a role in the economic security and sustainability of the network. The token’s value may be influenced by the demand for its various use cases.
Metrics Analysis and On-Chain Data Review
Markets
DOT currently has a circulating supply of 1,270,190,704 tokens, with a market cap of $5,404,384,911. This asset is listed on major centralized exchanges (CEXs) like Coinbase, Kraken, or Gemini.
Currently, Axelar DOT/OSMOS on Osmosis has a limited pool liquidity of around $200,000 with a 24-hour trading volume of around $2800.
DOT/OSMO on Osmosis:
| Markets | Liquidity | 24-hour volume | 2% Depth (USD) | 25% Depth (USD) |
|---|---|---|---|---|
| DOT/OSMO | $213,780 | $2800 | $1800 | $21,000 |
Major markets for DOT
| Markets | 24-hour volume | +2% Depth (USD) | -2% Depth (USD) |
|---|---|---|---|
| Coinbase Excahnge | $1,261,584 | $174,964 | $288,921 |
| Kraken | $755,752 | $993,458 | $494,988 |
Volatility
The following graphs show the frequency of day-over-day price changes of given magnitudes for DOT, WETH, and ATOM since DOT started trading. As shown in the figure, DOT has more frequent and significant price swings than ETH. Compared to ATOM, DOT is less volatile. DOT’s past 1 year 30D annualized volatility is estimated at around 63%, ATOM’s at 76%, and ETH’s at 60%.
- The maximum daily drawdown for DOT happened on 2021-05-20 when the price crashed 37% from $40.7 to $25.5 due to China’s crackdown on Crypto use.
- DOT is not a new asset. However, its trading history is only slightly more volatile than ETH but less volatile than ATOM.
- The time series below shows how DOT’s volatility has evolved since it started trading until July 23.
Daily Volume
The chart below shows DOT’s daily volume on the CEX exchanges. The daily volume of $92M in the past 24 H provides sufficient efficiency. The second figure shows that DOT’s volume has been trending stable this year.
Tail Risks Assessment
- Liquidity concern: DOT is the number 4 asset in terms of volume and market cap. However, there is only $200K liquidity in the pool for DOT/OSMOS in the pool with a 24H volume of $2000. This is relatively low. While the liquidators could bridge the token back to CEX and sell it, bridging takes extra transactions and time to complete. The liquidators might need more incentives to participate in the auction. Also, there might be fewer liquidators when we need to auction the asset.
Recommendations
DOT is not a new asset. However, the total liquidity of (Axelar) DOT on Osmosis DEX is relatively low at around $200k. Currently, axlDOT/OSMOS on Osmosis has a 24-hour volume of $2,000 with a 25% depth representing 5,000 tokens (approximately $21,000). Composable DOT (DOT.comp) has $1.5k in 25% depth. There is not enough on-chain liquidity from Cosmos DEXs to ensure the liquidations for DOT collateral are carried out efficiently. Liquidators can bridge DOT to CEX to liquidate the asset, but it will take extra incentives for them to do so.
Parameters
General Recommendations
Interest Rate → 2.5%
Our analysis suggests setting the initial interest rate to 2.5%, which aligns with stablecoin borrowing interest rates on other major DeFi lending platforms.
Liquidation Penalty → 10%
The liquidation penalty incentivizes users to manage their vaults to avoid liquidation. We recommend initializing it at 10%. This penalty is higher than other major lending protocols on Ethereum, as there is currently limited liquidity on the Interprotocol chain itself. This means that DOT vaults might not be liquidated in a single atomic transaction. Liquidators must hold the liquidated tokens for at least the length of a bridge transaction (~1 hour), which adds capital costs and risk to the process.
Minting Fee → $0
The minting fee is primarily a source of revenue for the protocol. It can be initialized at $0 to incentivize users to join IST.
Minimum Initial Debt → $50
The minimum initial debt prevents users from opening vault positions that would be too small to service. Dust vaults that cost more to liquidate than they are worth are effectively dead funds; effectively the same as insolvent collateral. The minimum should be set such that liquidations are always profitable net of transaction costs. We recommend setting it to $50, to be robust to relatively high transaction costs when the chain achieves greater adoption.
Option 1
| Parameter | DOT |
|---|---|
| Minimum Collateral Ratio | 210% |
| Liquidation Ratio | 180% |
| Mint Limit | $200,000 |
Liquidation Ratio
We derive the liquidation ratio based on our heuristic worst-case scenario simulation. Based on the historical data, we have seen a maximum of ~40% draw down on DOT in the past 2 years, and this represents the worst-case scenario in our analysis. We ran a heuristic simulation which is one user maxing out the Mint, with a very low collateralization ratio (at the point of getting liquidated). Based on the heuristic simulation result, we add an additional 10% to the liquidity ratio as a buffer to ensures the protocol would remain solvent ($0 insolvency) in the event of a 40% daily drawdown.
Minimum Collateral Ratio
We recommend the minimum collateral ratio based on the following formula:
Collateral Ratio = liquidation_threshold * (1 + (1 - EXP(-5 * volatility / 19.1)))
For this calculation, we have 1.8 * (1 + (1 - EXP(-5 * 0.63 / 19.1))) = 2.1
Where liquidation_threshold is the threshold at which a position becomes liquidatable, and volatility is the asset’s volatility.
The formula calculates the minimum collateral ratio required to prevent user positions from being very close to becoming liquidatable based on the past 1 year of the asset’s volatility, the EXP function is the exponential function, and the constants 5 and 19.1 are used to convert the asset’s annual volatility to daily volatility. The -5 is for 500% volatility multiplier (Black Thursday type level). So multiply the current asset’s volatility by 5 to simulate the asset’s annual volatility on Black Thursday. Dividing by 19.1 is just dividing by sqrt(365), which converts that annual volatility to daily volatility. e^(daily volatility) gives the 1 stdev percent drop. The formula will ensure that for the black Thursday drop, there’s enough of a buffer between the liquidation threshold and the initial Collateralization buffer to prevent liquidations.
Mint Limit
The mint limit is the maximum amount of IST that can be minted across all DOT-backed vaults. We recommend an initial value of $200,000 at the recommended LR, which is based on the 2% depth from the CEX from $200k to $1MM. The main risk is that due to the limited liquidity of DOT in Osmosis, liquidators need to bridge the collateral on other CEXs.
Option 2
| Parameter | DOT |
|---|---|
| Minimum Collateral Ratio | 230% |
| Liquidation Ratio | 210% |
| Mint Limit | $500,000 |
Liquidation Ratio & Minimum Collateral Ratio
The rationale is covered in Option 1. Here, Gauntlet recommends a more conservative LR and MCR recommendations with a more aggresive Mint Limit. A liquidation ratio of 210% (with an additional of 10% buffer) to ensures the protocol would remain solvent in the event of a 40% daily drawdown given the mint limit. (40% represents DOT’s maximum daily drawdown) while allowing borrowers to increase their capital efficiency by having higher collateral usage.
Mint Limit
Gauntlet suggests a $500k USD mint limit based on the CEX’s 2% depth witch is between $200k to $1MM. We apply a 0.5 “discount factor” for the liquidity since the liquidators would need to bridge the collateral from Cosmos. We believe the $500k Mint Limit will provide the initial growth for this asset. However, there is higher risk here due to the bridging.
Next Steps
We welcome community feedback and preference on the two options.
By approving this proposal, you agree that any services provided by Gauntlet shall be governed by the terms of service available at gauntlet.network/tos