This week we dig a little deeper into our rationale and the challenges we’ve faced in developing a new protocol. As we’ve seen this year, borrowing and lending in crypto can be a risky business which is why we’ve taken our time to thoroughly plan and think through the process.
Two essential lessons everyone should have learned in 2022 are that leverage is bad and giving away control of your crypto is a recipe for disaster. To ensure neither of these situations occurs with Paribus we’ve followed the safest approach of over-collateralization and decentralization through smart contracts.
Over-collateralization is designed to ensure there is sufficient headroom in tough market conditions to safely liquidate loans before they threaten the stability of the protocol. In practice, it means that users have to secure significantly more assets than they borrow which makes it the opposite of leverage.
The challenge for over-collateralization is how we reach a fair value for each NFT. Getting this right is crucial in setting the correct level of loan to value. If it’s wrong this can under-collateralize the loan and place the platform at risk.
Due to the increased complexities of valuing NFTs for loans we decided we wanted a more robust system than simply aggregating data from different pricing oracles. Although that approach works well for cryptocurrencies it is less than ideal for NFTs.
Wilson, our COO explains, “We wanted to build a system that aggregates valuations from as many sources as possible at any given time. As such we implemented our codebase to accept multiple valuations with the possibility of extending it to include more providers over time.”
Simon, our CTO adds, “This was a good step in achieving fair valuations but we felt it was not enough. So, we have put together an algorithm that consumes valuations from all of the plugged-in sources, then runs calculations from additional datapoints.”
He continues, “Inputs such as volume, average FP over the preceding weeks, and number of unique holders help to filter out potential wash trades. Additional weighted datapoints then return a ‘fair value’ that we believe captures the true value of the assets.”
Arriving at a fair value is just one part of the equation needed to protect Paribus from dangerous loan situations. As NFTs have more liquidity issues compared to cryptocurrencies we wanted to anticipate and prepare for challenging market conditions before they become an issue.
Deniz, our CEO describes this issue in more detail, “In attempts to avoid situations like the one BendDAO experienced a couple of months back where lots of collaterals were up for liquidation, we looked at the challenges of illiquidity that plague the NFT/Metaverse Land space. The biggest challenge is by far not finding the liquidity required to quickly close a loan.”
He continues, “This is why we went beyond typical NFT DeFi platforms and integrated at the SmartContract level directly with providers like NFTX and more. This will allow us to utilize some of the liquidity that is instantly available in DEXs.”
Taking all these factors into consideration we decided on a loan to value ratio of 60% to allow us sufficient headroom to be able to liquidate each NFT in turbulent market conditions. In addition we wanted to ensure we had an alternative system in place, running in parallel to our primary liquidation process.
As Wilson explains, “This is where we developed our discounted liquidation mechanism, where NFTs will be put up for sale by the protocol at a steep discount. It gives people the chance to buy and deposit the cash needed to liquidate a particular loan while also incentivising the original holder to close the loan before they lose their collateral.”
Deniz adds, “As can be seen, a lot of thought and time was spent in preparing both appraisals and liquidations. We are confident in our solution but we will continue to monitor and improve over time. Our aim is to make the entire protocol as capital efficient as we can going forward.”