Liquidity Impairments address default risk by adjusting the MasterPool value, and redistributing MasterPool Units to manage defaults effectively.
When liquidity is extended to customers, there is always a risk that they may fail to fulfil their obligations to repay, commonly known as default risk. While we can mitigate this risk through effective onboarding procedures, credit-scoring models, and diversification strategies, it is important to recognize that it cannot be completely eliminated.
The liquidation process is initiated by MoneySwitch when a customer’s liquidity repayment is past due, and all efforts to recover the repayment have been unsuccessful. This process entails adjusting the MasterPool Value to account for the impairment amount and redeeming MasterPool Units from FeederPools. As a result, the FeederPool Value for each FeederPool will be diminished. Consequently, the value of a depositor’s holdings in a FeederPool, which is tied to the respective FeederPool Value, will also be reduced as a consequence of this process.
While it is technically feasible to adjust only the MasterPool Value for the impairment, this approach would distribute the impact evenly across all FeederPools. However, by adjusting the MasterPool Units of each FeederPool, we can control how the liquidity impairment affects different FeederPools. To achieve this, we utilize the ‘Impairment Rank’ assigned to each FeederPool, indicating its seniority concerning impairments. FeederPools with lower Impairment Ranks are impaired prior to those with higher ranks. It’s worth noting that there are no restrictions on FeederPools sharing the same Impairment Rank.
This approach provides the advantage of offering diverse levels of default risk exposure across FeederPools, thereby catering to depositors with different risk profiles. Additionally, we can adjust lock-up periods and token-based rewards to appropriately compensate for varying levels of risk exposure.