Minimum Collateral Ratio

Setting the MCR is a fundamental governance decision balancing capital efficiency against system solvency. Key considerations include:

• Collateral Volatility: More volatile assets require higher MCRs.
• Oracle Security: Reliance on price feeds necessitates safety buffers.
• Liquidation Efficiency: Protocols with slower/riskier liquidation mechanisms need higher MCRs.
• Market Conditions: DAOs often vote to adjust MCRs during high volatility (e.g., increasing ratios to reduce systemic risk).

The Minimum Collateral Ratio (MCR) is the lowest permissible ratio of a position's collateral value to its borrowed value (or generated stablecoin debt). Its primary purpose is to maintain protocol solvency by ensuring all outstanding debt is sufficiently backed, even during market volatility. If a user's collateral ratio falls below the MCR, their position becomes eligible for liquidation to repay the debt before it becomes undercollateralized.

When the real-time collateral ratio dips below the MCR, it triggers a liquidation event. This automated process typically involves:

• A liquidation penalty (or fee) being applied to the debt.
• A portion of the collateral being sold (often at a discount) on the open market or to designated liquidators.
• The proceeds are used to repay the user's debt, with any remaining collateral returned to the user. The goal is to protect the protocol from bad debt while incentivizing third parties to participate in the liquidation mechanism.

A significant risk associated with MCRs is a liquidation cascade or death spiral. During sharp market downturns, many positions can become undercollateralized simultaneously. The resulting wave of forced liquidations can:

• Depress the price of the collateral asset further via mass selling.
• Create a feedback loop, pushing more positions below their MCR.
• Potentially overwhelm the liquidation system and lead to bad debt if collateral cannot be sold for enough to cover the loans.

Setting the MCR is a key governance decision that balances risk and capital efficiency. A lower MCR allows users to borrow more against their collateral (higher capital efficiency) but increases protocol risk. A higher MCR is more conservative but reduces borrowing power. Governance must consider:

• The volatility and liquidity of accepted collateral assets.
• The speed and reliability of the oracle price feeds.
• The efficiency of the liquidation mechanism.

For users, the key metric is the Health Factor, which is their collateral ratio divided by the MCR. A Health Factor of 1.0 means the position is at the liquidation threshold. To avoid liquidation, users must maintain a significant safety buffer above the MCR. This buffer accounts for:

• Price slippage during volatile markets.
• Potential oracle price delays.
• Liquidation incentive discounts that require selling more collateral than the nominal debt value.

It's crucial to distinguish between the Minimum Collateral Ratio (MCR) and the Liquidation Ratio (LR). While sometimes used interchangeably, they can represent different thresholds in some protocols.

• MCR: The absolute minimum ratio before a position is eligible for liquidation.
• LR: Often the ratio at which the liquidation process is initiated or becomes most profitable for liquidators. The LR may be set slightly higher than the MCR to create a buffer for the liquidation process itself, ensuring it can complete before the position becomes truly undercollateralized.

The Liquidation Ratio is the specific collateral-to-debt threshold at which a position becomes eligible for liquidation. It is typically set slightly above the Minimum Collateral Ratio (MCR) to create a buffer. For example, if the MCR is 150%, the liquidation ratio might be 155%. This buffer gives the protocol time to initiate and execute the liquidation process before the collateral value falls below the absolute minimum required for solvency.

The Collateral Factor (or Loan-to-Value Ratio, LTV) is the inverse of the collateral ratio. It represents the maximum percentage of an asset's value that can be borrowed against. A 150% MCR corresponds to a ~66.7% LTV (1 / 1.5). This is a core risk parameter set by protocol governance, determining borrowing limits and the protocol's overall risk exposure to volatile collateral assets.

The Health Factor is a real-time, user-facing metric that indicates how close a borrowing position is to liquidation. It is calculated as (Collateral Value * Liquidation Threshold) / Borrowed Value. A health factor of 1.0 means the position is exactly at the liquidation threshold. Users must maintain a health factor > 1.0 to avoid liquidation. It dynamically updates with market prices, providing a direct, actionable view of position risk relative to the MCR.

Liquidation is the enforced process of selling a borrower's collateral to repay their debt when their collateral ratio falls below the protocol's Liquidation Ratio. This mechanism protects the protocol from insolvency. It is often performed by third-party liquidators who are incentivized by a liquidation bonus (a discount on the collateral) for repaying the debt. The MCR defines the solvency floor that liquidation is designed to defend.

Overcollateralization is the foundational principle requiring borrowers to lock assets worth more than the value of the loan they receive. The Minimum Collateral Ratio quantifies the required degree of this overcollateralization. It is a trust-minimizing design that secures loans without requiring credit checks, as the collateral itself, if sufficiently overvalued, guarantees loan repayment even under market volatility.

The Stability Fee (or borrow interest rate) is the ongoing cost paid by borrowers on their debt. Governance often adjusts interest rates in relation to risk parameters like the MCR. For riskier collateral types (e.g., volatile assets), protocols may set both a higher MCR (requiring more safety) and a higher stability fee to compensate for the increased systemic risk and incentivize maintaining healthy collateral buffers.