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Liquations Overview

"Liquidation" is a term used in decentralized finance (DeFi) to describe a process that ensures the stability and health of a lending protocol. It's not something the protocol actively does, but rather a mechanism built into it. The protocol typically provides a dashboard that displays open positions and their health factors, along with a feature to flag a user's position for liquidation. This process is then triggered by a community of liquidators, further decentralizing the system and reducing the gas cost of maintaining its health.

In the trustless world of DeFi, there's no way to enforce mandatory loan repayments. So, how do lending protocols ensure that lenders don't repeatedly suffer losses? The answer lies in Collateralized Debt Positions (CDPs). All positions on a lending protocol are overcollateralized, meaning that anyone with a loan will always have deposited more than the amount they borrowed. This setup incentivizes borrowers to repay their loans to avoid losing their collateral and helps protect lenders from bad debt.

When a borrower's position becomes eligible for liquidation, liquidators trigger an auction process for the borrower's collateral. Liquidators bid increasing amounts of an asset, such as DAI, for the discounted liquidated collateral. It's important to note that not all of a borrower's position will be claimed during liquidation. Partial liquidations occur where only the necessary portions of the collateral required to restore the borrower's health factor to a safe level are sold.

The protocol claims a portion of the liquidated collateral for itself, while the liquidators compete for the rest. Each asset eligible for deposits on a lending market will have a liquidation fee or penalty associated with it. This fee is the payment a borrower makes directly to the protocol for being liquidated. Protocols vary in how they distribute this fee to incentivize liquidators to efficiently maintain the health of the system.

MakerDAO Liquidations

Liquidation is the process of selling collateral to cover the amount of Dai a user has minted from their Vault when the loan-to-value (LTV) ratio crosses the predetermined threshold. It ensures that Dai is always backed by enough collateral (in USD terms)  by closing-out Vaults that are under their minimum required Collateralization Ratio. Liquidations are triggered automatically by the protocol in which the protocol sells/auctions enough of the collateral off to service the debt plus a Liquidation Penalty. The Protocol determines after comparing the Liquidation Ratio to the current collateral-to-debt ratio of a Vault. Each Vault type has its own Liquidation Ratio, and each ratio is determined by MKR voters based on the risk profile of the particular collateral asset type.

In May of 2021, Maker introduced Liquidations 2.0  after deficiencies in its prior liquidation method became apparent. The liquidation is actually an auction that anyone can participate in, and bidders in these auctions are known as Auction Keepers. They are external actors that are incentivized by profit to automate certain operations around the Ethereum blockchain. Proceeds from Liquidation Penalties are put towards the Surplus Auctions, which result in burned MKR.

Since then, liquidations are not handled via a single Dutch auction. In a Dutch auction, the collateral is initially priced at a high bid that gradually decreases until a buyer is buys at that price. If no buyer is present, the collateral continues to be discounted up to a predefined limit or until the auction ends.

In this scenario, potential liquidators must constantly decide whether to purchase at the present price or wait until the discount increases. If the second option is selected, the potential liquidator risks losing the asset to a competitor who is willing to purchase at a slightly higher rate. Thus, liquidators will choose to liquidate when the bid is profitable enough for them to accept.

Dutch auctions enable larger loans to be profitably liquidated at a reduced discount percentage compared to smaller loans.  Consequently, the discount can scale more effectively with gas prices over that period. During periods of network congestion, a greater percentage discount will be required to conclude the auction than during periods of network slack, all else being equal.

Source: Delphi Digital

Conclusion

We have established that when the value of a loan's collateral falls below the value of the borrower's outstanding debt, including interest, the under-collateralized position poses a threat to the health of the lending protocol. To prevent the accumulation of under-collateralized positions, DeFi protocols enable third parties, who may not be users of the protocol, to repay the debt of under-collateralized or near-under-collateralized borrowers. By paying off these debts, these third parties, known as liquidators, can claim the collateral of the borrowers they cover at a discounted price. This process is referred to as liquidation.

You might wonder why protocols rely on third parties for liquidating unhealthy positions rather than incorporating an automatic liquidation mechanism into their code. The reason lies in the high gas costs associated with sending liquidation transactions. If a protocol were to automate this process, the resulting gas expenses would significantly increase operating costs, potentially undermining profitability.

Moreover, designing an automated liquidation system is highly complex. A protocol would need to determine not only whether a position should be liquidated but also when to do so, taking into account market volatility. It is more feasible to delegate this task to specialized third parties by providing incentives for them to liquidate these positions.

Liquidation is not inherently profitable; it becomes so only when a debtor's collateral is worth more than their outstanding debt. Liquidators will not engage in liquidation without the assurance of profitability.

But when does a position become eligible for liquidation? This criterion is determined by the protocol, as a function of the liquidation threshold assigned to each asset.

Timing is crucial when it comes to liquidation thresholds. As we have discussed, if a position's debt value surpasses its collateral value, liquidation becomes unprofitable for liquidators, leaving the protocol burdened with bad debt. Consequently, secure liquidation thresholds must provide liquidators with sufficient time to liquidate over-collateralized positions before they become insolvent, thus maintaining the overall stability of the lending protocol.