The risk parameters allow to mitigate market risks of the currencies supported by the protocol. Each borrowing is guaranteed by a collateral that may be subject to volatility. Sufficient margin and incentives are needed for the position to remain collateralised in adverse market conditions. If the value of the collateral falls bellow a threshold, part of it is auctioned to repay part of the position and keep the ongoing borrowing collateralised.
From Risks to Risk Parameters
Market risks have the most direct impact on the risk parameters:
The liquidity is based on the volume on the markets, which is key for the liquidation process. This can be mitigated through the liquidation parameters: the lower the liquidity, the higher the incentives.
The volatilityof price can negatively affect the collateral which safeguards the solvency of the protocol and must cover the liabilities. The risk of the collateral falling below the borrowed amounts can be mitigated through the level of coverage required, the Loan-To-Value. It also affects the liquidation process as the margin for liquidators needs to allow for profit.
The market capitalisation represents the size of the market, which is important when it comes to liquidating collateral. This can be mitigated through the liquidation parameters: the smaller the market cap, the higher the incentives.
The overall risk rating is used to calibrate the Reserve Factor with factors ranging from 10% for the less risky assets to 35% for the riskiest.