Liquidations
In order to maintain the health of the protocol, liquidations are put in place to ensure that every debt position (loan) has sufficient collateral backing it. Should there be a scenario where a user's health factor falls to 1 or lower, a liquidation occurs.
A user's health factor falling can be due to 2 reasons:
Collateral value decreases
Loan value increases
A user may increase their health factor by either depositing additional collateral or repaying their loans.
What happens during a liquidation?
In the process of liquidation, liquidators (bots or other defi users) monitor exisiting positions to find loans that are eligible for liquidation.
By interacting with our contracts, liquidators are able to pay back part of a user's debt in exchange for discounted collateral, bringing back a user's health factor to a healthy range.
This discounted collateral is calculated based on the liquidation penalty set out for each asset. Half of the penalty will be given to the liquidators as rewards, with the other half retained by the protocol for stakers and treasury.
Maximum Liquidation
When Health Factor > 0.95 (Normal)
In this scenario, liquidators can only liquidate and pay up to 50% of a user's debt. Thus, if a user has $1000 in loans and is eligible for liquidations, only $500 can be repaid.
This is to ensure that there are no liquidation cascades or additional market volatility should a liquidation occur.
When Health Factor <= 0.95 (Risky)
In this situation, the protocol has deemed a user's position to be risky for overall protocol health and thus, 100% of the user's debt can be liquidated. Thus, if a user has $1000 in loans and is eligible for liquidations, all $1000 can be repaid.
Liquidation Penalty
A liquidation penalty is put in place to reward liquidators for the efforts to maintain the health of the protocol. Thus when a user is liquidated, an additional portion of their collateral is deducted to be distributed to liquidators.
Current liquidation penalty can be found here.
Liquidation Scenario
A user has $1000 BTC collateral (80% collateral ratio) and $700 in USDC loans. They thus have a health factor of $1000*80%/$700 = 1.14
BTC value drops, resulting in the collateral value decreasing to $850. Health factor is now $850*80%/$700 = 0.971, making the user eligible for liquidation.
A liquidator can repay up 50%, or $350 of the $700 loan. In this scenario, they repay the maximum amount. Assuming the liquidation penalty is 10%, with a 2.5% protocol liquidation fee, the liquidator can now claim a 7.5% bonus collateral on addition to what they repaid. with 2.5% bonus flowing to protocol treasury
Example:
The liquidator claims $350 BTC (repaid amount)
An additional $35 BTC (10% of repaid collateral) is claimed from the collateral as the liquidation penalty
$26.25 (7.5% of repaid collateral) is given to the liquidator and the remaining 2.5% flows back to the protocol as a fee
This results in the user having a $350 loan with ($850 - $350 -$35) = $465 in BTC collateral
The user's health factor is now $465*80%/$350 = 1.062, which is above 1.
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