Collateral top-ups through Backd
The Backd protocol deploys reactive liquidity pools which enable users to register Actions to their provided liquidity. Specifically, this enables LPs to autonomously delegate their liquidity to where it is the most efficient (while earning yield and rewards). The first Action that Backd will support is collateral top-ups. In this post we are going to focus on Backd’s first Action and explain how users can use Backd top-ups to make borrowing more efficient along with an overview of how top-ups work.
Refer to the docs for extensive information on Backd Actions.
Protocols for loanable funds (PLFs), such as Compound and Aave, are key financial instruments for DeFi users. With a combined TVL in the billions their use case continues to grow as investors seek better ways to leverage or hedge their assets. However, utilizing these protocols to borrow assets comes at a cost due to several reasons.
🔴 Over-collateralization: Users can borrow a limited dollar amount of an asset against their collateral.
🔴 Volatility: Market conditions create loans with rapidly changing LTV ratios. Users have to manually maintain a healthy LTV or risk liquidation.
🔴 Liquidation risk: As a user increases the amount they borrow relative to the value of the posted collateral, they also increase their liquidation risk.
🔴 Capital inefficiency: Users must decide between increasing collateral and earning yield on other protocols — “Should I play it safe, or farm more yield?”
Backd eliminates these borrowing burdens and makes maintaining a healthy debt position nearly stress free. On Backd liquidity providers can use their deposits as back up collateral for their DeFi loans (on supported PLFs). Specifically, this enables borrowers to make better use of their collateral through deploying it to earn yield and rewards, rather than sitting idle.
What are collateral top-ups❓
A collateral top-up simply means injecting additional capital into a collateralized position in order to avoid liquidation. This can be done manually, however utilizing automated top-ups through Backd is far more efficient. The first step to setting up your collateral top-ups is depositing assets into one of Backd’s single-asset pools in exchange for LP tokens. In the pool your assets are allocated to a protocol-specific vault to earn yield (more on Backd yield in the next post). Now that a user has Backd LP tokens they can register some or all of them for collateral top-ups (Note: top-up registration is optional). Liquidity that is registered for collateral top-ups will continue to aggregate yield until the user’s registered health factor is reached.
The Health Factor 👨⚕️
In order to register effective collateral top-ups it is important users understand the health factor. The health factor is a numerical representation of the safety level of a loan. It is used for both triggering liquidations on PLFs and collateral top-ups on Backd. Maintaining a high health factor keeps a user’s loan safe from liquidation. If the health factor drops below 1 it is eligible for liquidation. Backd users should always set their health factor above 1.05 to avoid gas wars with liquidation bots. If the health factor is set too close to 1 a liquidation bot could theoretically out bid the Backd keeper and the users funds could be liquidated instead of topped up.
Hf = (Total Collateral in ETH x Liquidation Threshold) / Total Borrows in ETH
Registering a Position for Top-up🧾
In order to register a position for collateral top-ups, the following information must be provided by the user:
- The Protocol on which the user is borrowing on (currently compatible with Aave and Compound)
- The address of the owner of the position to top-up (e.g. if Alice is the borrower on Aave that should be topped up then this would be Alice’s address).
- The health factor threshold a collateral top-up should occur at
- Amount of a single top-up increment (e.g. top-up increments of 2,500 DAI)
- Total top-up amount (value of your liquidity allocated for top-ups)
Now that the user has entered the top-up parameters they will need to complete two transactions (approval of LP token spending and registration). After this, the user is fully registered and collateral top-ups will be executed automatically via the Backd protocol if the registered health factor is reached.
Users can unregister their LP tokens at anytime.
The above image depicts how a Backd collateral top-up protects a collateralized debt position from being liquidated. In this example a user registers a loan with the following parameters:
User’s Initial Loan
Liquidation Threshold: 80%
Health Factor: 1.066
Backd Top-up Registration
Health factor: 1.05
Top-up Increments: $2,500
Max top-up allocation: $10,000
In this example, an Aave user is utilizing ETH as collateral to borrow DAI. Market conditions have caused ETH to drop in value and now the user has a loan to value ratio of 76% and a health factor of 1.05. This loan is now at a high risk of liquidation. However, the user has the loan registered for collateral top-ups via Backd. Backd keepers are constantly monitoring the health factor of the user’s loan and immediately notify the Backd smart contract when it hits the health factor threshold (1.05). At that point, the Backd smart contract deposits the top-up increment ($2,500) into the Aave user’s collateral and prevents liquidation. In return for this, the Backd keeper receives a small top-up fee that is deducted from the user’s max allocation.
This is an example of how the Backd protocol can be used to increase leverage. Increasing leverage comes at the cost of higher liquidation risk. The user was able to mitigate liquidation risk and maintain a lower risk health factor by registering his loan on Backd. Additionally, the user was able to decrease the cost of borrowing thanks to Backd’s reactive liquidity. While the user’s funds were registered they were earning interest until they were needed for top-up. When the top-up occurred it generated a “top-up fee.” This fee is split between Backd LPs, Backd governance token holders, and the Backd keeper who reported the top-up. Backd collateral top-ups are not only a service to users. They also generates profit for the protocol as a whole.