Liquidation is the process of selling collateral to cover the amount of H2O a user has generated from the Vault. A Vault will be liquidated if the value of its collateral falls below the required minimum level, called the Minimum Collateral Ratio. During the Liquidation process, enough collateral is sold to cover the debt along with a Liquidation Penalty, leaving the remaining collateral available for withdrawal.
How is liquidation triggered?
When the actual collateral rate of the user's trove is less than the Minimum Collateral Ratio of the corresponding vault, the liquidation process will be triggered. Any third-party user can implement the liquidation choosing to pay part of the H2O and obtain the ownership of the equivalent amount of the collateral (LP token).
Liquidation Reward is the mechanism to incentivize liquidators to liquidate the positions falling out of the minimum collateral threshold. Liquidation Reward can be simply regarded as the discount, or additional amount of the collaterals, given to the liquidators to acquire possession of the collaterals in the process. Normally, Liquidation Reward is higher than the Liquidation Penalty.
A Liquidation Penalty is a fee that is paid when vaults are liquidated. The fee is added to the Reserve Pool when a Liquidation occurs, which leads to more of the collateral being sold. In other words, it results in losing more collateral by the user being liquidated.
What happens in liquidation?
Liquidation involves three parameters: Minimum Collateral Ratio, Liquidation Reward, and Liquidation Penalty. The vault where different LP tokens are located corresponds to different parameters. When liquidation triggers, the liquidator, the liquidated party, and the Reserve Pool will receive their corresponding parts.
The liquidation operations look like this:
- The protocol detects a Vault falling out of the collateral requirement and triggers a liquidation. Users can check the positions open for liquidation on the Dapp interface.
- All of the collateral is put up for liquidation to cover the outstanding H2O debt + Liquidation Penalty.
- Liquidation Rewards incentivize liquidators by giving them discounts. The first user getting the transaction on-chain will be the final liquidator of the vault.
- Once the liquidation completes, the liquidator receives the equivalent amount of the collateral, the liquidator's H2O as principal is burned, the Liquidation Penalty, as well as the accrued Stability Fees, are transferred into the Reserve Pool, and the Vault owner receives leftover collateral if any remains.
Assume that the vault corresponding to a certain LP Token has a minimum collateral ratio of 150%, a Liquidation Penalty of 10%, and a Liquidation Reward of 20%. When Alice deposits 10 LP Tokens with a total value of USD$200 and borrowed 100 H20, the collateral rate is 200%. If later, the total value of 10 LP Tokens drops to USD$150, liquidation is triggered. The total debt of the vault is 101, including 1 H2O as the Stability Fee. At this time, Bob as a third party initiates the liquidation of Alice's vault.
- Bob needs to pay 111.1 units of H2O for liquidation. (Outstanding H2O Debt $101 x (1+Liquidation Penalty 10%))
- Bob gets 8.08 units of LP tokens, equivalent to $121.2 from the liquidation. (Outstanding H2O Debt $101 x (1+ Liquidation Reward 20%) / current value per collateral token $15)
- Alice's remaining LP tokens after liquidation is 1.92 units. (Original Collateral Amount 10 - the Number of Collateral obtained by the Liquidator 8.08)
- The Reserve Pool gets 11.1 units of H2O tokens. (Outstanding H2O Debt $100 x Liquidation Penalty 10% + Outstanding Stability Fee 1 x (1+ Liquidation Penalty 10%))
- The number of H2O burnt is 100.
Ensuring that assets remain safe from liquidation is entirely within the hands of each Vault user. Below are some common practices to monitor the health of a Vault:
- Set up price alerts for the collateral assets being used.
- Set up a personal rule that would require you to unwind their vaults if the collateral price falls below a certain level.
- Make sure you have adequate access to the vaults, especially during volatile periods.
- Make sure you have access to emergency funds or assets that can be readily used to pay back H2O or add more collateral to their positions.
Remember that opening a Vault and generating H2O represents the creation of risk. Defrost Protocol users should use leverages at their own risk.