Each collateral asset has an LVR that defines the ratio of loan value that a user can take out against a given value of its collateral. Loans are overcollateralized; thus, the LVR is always less than 100%. For example, a collateral asset with an LVR of 60% would allow users to take out a loan of up to 60% of their collateral value.
The method to determine LVR is to analyze the price history of the collateral asset and gauge its maximum price falls over the interval of time within which liquidations are reasonably likely to take place. A period of four hours is used to assess an asset’s volatility.
The four hours threshold was established due to the competition between liquidators to be the first to liquidate a loan resulting in a strong incentive to perform liquidations quickly. Simultaneously, liquidators may not always be able to immediately perform a liquidation when a loan falls below its minimum collateralization.
The below diagram illustrates our approach by displaying discrete four-hour periods. The actual methodology applied in Fringe Finance uses continuous four-hour periods. This simplification makes the diagrammatic depiction more intuitive.
Analysis of an asset’s maximum volatility within a four-hour period.
When analyzing historical price data, an asset’s initial weeks of trading might be excluded from the dataset due to the highly volatile nature of such low liquidity periods. Such early-stage volatility is generally not reflective of long-term later patterns.
When loans are liquidated, the underlying collateral is subsequently sold by liquidators, potentially causing slippage in its price. To take into account the impact of liquidations on the price, we multiply the worst expected volatility over a four-hour period by a slippage threshold. The slippage threshold is calculated based on the maximum slippage we expect from all loans secured by a collateral asset being liquidated simultaneously.
As mentioned, a conservative factor is then applied to the maximum price drawdown, including the slippage threshold, to arrive at the final LVR used by the Primary Lending Platform. This conservative factor considers a 5% slippage, therefore reducing the LVR to 0.95 times its original calculation. In the example presented in the diagram, this results in the following calculation: