Liquidation Mechanism in Blockchain.
Gideon Shadrack
Definition of Liquidation:
Liquidation, within lending and borrowing protocols, entails seizing a borrower’s collateral and repaying the debt through a third party. This action is typically triggered when the collateral’s value drops below a specified threshold in comparison to the borrowed amount, signaling a precarious position eligible for liquidation by bots or individual users.
Significance of Liquidation:
Liquidation plays a pivotal role in ensuring the health and stability of lending and borrowing protocols. It acts as a safeguard, maintaining the protocol’s solvency. By swiftly and effectively seizing collateral and settling debt, liquidation prevents the accumulation of bad debt.
Instances Leading to Liquidation:
The occurrence of liquidation is linked to a user’s Loan-to-Value (LTV) ratio surpassing a predetermined threshold. The LTV ratio, measuring borrowed funds against collateral value, becomes a red flag when exceeding the protocol-defined limit, often set around 80%. This breach indicates potential risk, triggering the liquidation process.
Illustration of Liquidation with an Example:
Consider a scenario involving two users, Alice and Bob:
Alice pledges 1,000 USDT as collateral.
Alice borrows 0.3 ETH, valued at 660 USD at the time (ETH price = 2,200 USD), resulting in a 66% LTV ratio.
Shift in ETH Price:
The ETH price rises to 2,700 USD, increasing the value of Alice’s borrowed amount. This shift raises her LTV to 81%, surpassing the 80% liquidation threshold.
Bob’s Involvement:
Bob, another user, identifies Alice’s vulnerable position and decides to initiate the liquidation process.
Steps in the Liquidation Process:
Bob invokes the liquidation function, specifying Alice’s address and the desired liquidation value.
Most protocols have safeguards, allowing only a portion (e.g., 50%) of the debt to be liquidated at once.
Execution of Liquidation:
Bob repays 0.15 ETH (405 USD) on behalf of Alice, liquidating 50% of her debt. In return, Bob acquires Alice’s collateral, usually with an added penalty (e.g., 5%). The penalty ensures that Bob pays 405 USD but receives 425.25 USDT from Alice’s collateral, altering Alice’s LTV.
Post-Liquidation Position:
Alice’s position is adjusted post-liquidation, reflecting a healthier LTV of 70.46%. Her collateral is now 574.75 USDT, and the remaining debt is 0.15 ETH (405 USD).
Protocol-Specific Conditions and Scenarios:
Distinct protocols may introduce unique conditions, such as maximum liquidation values relative to position size, to minimize borrower losses.
Special Scenarios:
Certain situations, like substantial penalties leading to a more precarious LTV ratio, can impact the borrower’s position.
Extreme Cases:
In rare instances, the liquidation plus penalty might surpass the provided collateral, necessitating protocols to implement safeguards, such as reverting the liquidation attempt and only paying the provided collateral.
Key Insights for Borrowers:
Liquidation Penalty: Opting for a protocol with a reasonable liquidation penalty is essential.
Speed of Liquidation: Swift liquidation contributes to protocol health and minimizes borrower loss.
Token Volatility: Protocols often set lower LTV limits for tokens with higher volatility to mitigate risks.
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Posted Feb 4, 2024
https://medium.com/@gedions808/liquidation-mechanism-in-blockchain-bfad5bfc7f9a
