⏹️Liquidation Mechanism

Liquidation plays a pivotal role in the stability and functionality of lending protocols, especially in platforms that permit the borrowing of multiple assets concurrently. Unlike traditional platforms that limit borrowing to a single asset, our protocol embraces a vision of openness and flexibility. This approach enables users to leverage a broader range of assets for borrowing, thereby expanding their lending and investment opportunities. However, the inclusion of multiple assets introduces complexity to the liquidation process, necessitating a detailed explanation to ensure user comprehension.

The Liquidation-Risk Factor

At the core of our liquidation mechanism is the Liquidation Risk [LR], a dynamic metric that assesses the risk associated with each loan. The LR is calculated as follows:

LR= TotalDebt[$]\div TotalCollateral[$]

With:

$$TotalDebt = BorrowedAmount + InterestsOwed$$

$$TotalCollateral = SuppliedAmount + InterestsAccrued$$

This percentage reflects the loan's current liquidation Risk. The higher it's, the higher is the risk of being liquidated. With its value fluctuating in response to the volatile nature of the assets involved. Two critical thresholds are defined for the LR:

• LR = 75%: A warning level where the user is prompted to either repay part of the loan or increase their collateral to decrease the LR. You will Immediately notice it when you login into the platform and you check the progress bar, representing the current LR value on your dashboard.

• LR = 85%: The liquidation threshold. Beyond this point, the loan is at risk of liquidation to prevent potential insolvency of the platform.

Liquidation Process: A Practical Example

Imagine Luigi borrows $800 worth of tokens using $1,000 worth of his own assets as collateral (and he didn't earn or owe any interest). This means his initial LR sits at 80% ($800 debt / $1,000 collateral). However, if Luigi borrow value raises to 850$, his LR raises to 85% [850$/1,000$], making his loan elebigle for the liquidation. In this scenario, a liquidator can step in by repaying the outstanding debt of $850, plus interesty owed by Luigi for his loan. The liquidator is then compensated with the borrowers's debt.

Here's how it works: 

The liquidator pays off Luigi's debt ($8500) plus interest (Let's simplyifing saying there are no). In return, they receive:

1. Luigi Collateral 1,000$;

2. Luigi Interests Accrued - If for example Luigi earned 10$ from supplying 1,000$, they are sent to the liquidator too.

Luigi loses: 

1. The Liquidation Penalty. Let's supposed the liquidation happens at LR = 85%, it will be complementary to the LR, so it's 15%. Luigi loses 150$, since he will remain with no active borrows on the platfor, while he keeps his borrowed amount, actually worth 850$.

2. Sirio receives 20% of the Liquidation Penalty (this is called Liquidation Fee). So 20% of 150$ is sent to Sirio (30$) while Liquidator makes a net profit of 120$.

Ultimately, this process helps protect the platform from financial instability while still offering borrowers opportunities. However, it's important for borrowers to understand and manage their Health Factor to avoid liquidation. More informations on these parameters can be found in the Risk Framework section.