Liquidations
What are liquidations?
Liquidation is the process of selling collateral and repaying debt to make sure that there is enough collateral backing the MAI from a vault. Liquidations occur when some or all of the collateral in a vault is sold by someone other than the owner of the collateral to cover the costs of repaying the vault's debt.
Any vault whose collateral to debt ratio falls below the liquidation ratio can be partially liquidated. Each vault type will have its own liquidation ratio, based on the risk profile of the particular collateral asset type. This is to ensure there is always sufficient collateral in the vaults to cover all outstanding debts.
What is the collateral to debt ratio?
The collateral to debt ratio represents the relationship between the value of locked collateral in a vault and the debt that the vault has outstanding. In our protocol, collateral are the tokens locked in a vault. To ensure a healthy protocol, there should always be enough collateral value to back the MAI that have been issued. To accomplish this, vault owners must maintain a minimum collateral to debt ratio. This minimum collateral to debt ratio is referred to as the liquidation ratio, because vaults that fall below this threshold incur a liquidation penalty.
How do liquidations work?
When vaults fall below the liquidation ratio, liquidators repay 50% of the vault’s debt and withdraw a portion of the locked collateral tokens as compensation. The vault will then be returned to the original vault owner at a healthy collateral to debt ratio. To liquidate a vault, users have to identify a risky vault and click buy risky vault. This will automatically carry out the liquidation process if the liquidator has enough MAI. Liquidators must have enough MAI to carry out liquidations.
How do liquidations differ from other protocols?
Unlike all other major lending markets, QiDao does not have the "death spiral" risk. This risk comes from the bonus taken on liquidations. If the overcollateralization of a vault (collateral to debt ratio minus 100%) is below the percentage bonus taken on liquidations, then any liquidation procedure will only decrease collateralization. This has resulted in significant bad debt at other lending markets.
The graph above shows how the collateralization of a debt position changes with each marginal liquidation after the death spiral point has been reached (CDR - 100% < liquidation bonus).
The way QiDao fixes this issue is via the buyRisky function. This function changes liquidations from repaying debt to buying the entire debt position at the inflection point of the death spiral. BuyRisky transfers unhealthy loans from the original owner to the liquidator. This is at no cost to the liquidator. However, the liquidator must then repay enough MAI debt in order to regain healthy status. Otherwise, other actors may execute the buyRisky function. Liquidators have an incentive to exercise this option as it provides them with a small bonus from the overcollateralization of loans. Even at <100% collateralization, this presents a great opportunity to acquire collateral assets at low slippage, or sell MAI at low slippage.
You got liquidated, now what?
The QiDao Protocol has enabled partial liquidations, meaning that if your vault falls below the liquidation ratio, you will only lose part of your collateral. You will still own your vault, and some of the debt will have been paid off. This will bring your vault above the liquidation ratio and thus make it no longer risky. Vaults can undergo partial liquidation multiple times if they continue to become risky.
What is the penalty for getting liquidated?
Arriving at how much you lost when you’re liquidated has two parts:
First is the stablecoin debt that is repaid for you to bring your vault into good standing again. This is a gain.
Second is the collateral that is sold to compensate liquidators. This is a loss.
Liquidators will take enough collateral to make up for the debt they repaid for you, plus an added bonus to give them a return on investment. This is the collateral lost. The debt that is repaid by the liquidator is no longer owed by you. As a result, the portion of the debt that was paid off now becomes an asset. So, your penalty is the gain from the debt being repaid minus the collateral you lost.
Example of partial liquidation process:
A vault with a value of $100,000 USD in MATIC borrows the max allowed collateralization ratio (150%) and receives 66,666.67 MAI (valued at $66,666.67 USD). If the value of MATIC in the vault drops to $95,000 USD and the remaining loan balance remains at 66,666.67 MAI, the vault is now undercollateralized (142% collateral to debt ratio). This triggers the ability for someone to partially liquidate the undercollateralized vault by paying down 50% of the vault’s debt. In this case, that would mean paying 33,333.33 MAI. After doing so, the user liquidating the vault would then withdraw $33,333.33-worth of MATIC tokens, plus a 10% bonus ($3,333.33-worth of MATIC). The vault is then returned to the original owner.
The net profit for the liquidator would be 10% and the net penalty for the owner of the risky vault would be around 3.5%.
The repayment fee (0.5%) is taken out of the vault collateral when the MAI debt is repaid.
Why do we have liquidations?
The value of the stablecoins created by users is backed by the collateral held in vaults. If the collateral value in vaults falls below the value of the stablecoins in the protocol, then the system would become insolvent. This would mean that the stablecoins in the network are not fully backed by enough value. To avoid this scenario, vaults must always have more value in collateral than the value of their debt. Vaults use the penalty of liquidation to incentivize users to maintain healthy collateral to debt ratios.
Why do we do partial liquidation instead of full liquidations?
To lower the amount of collateral vault owners would lose during scenarios of liquidation
To increase user capital efficiency
DeFi is for everyone. We want to make our protocol as inviting as possible to these users, regardless of their wealth or knowledge of DeFi. We do this by making our protocol a safe place for people to interact and learn about DeFi. That being said, liquidations are an important mechanism of a healthy protocol and we have sufficient measures in place to guarantee the protocol’s integrity.
Are Liquidations of stable vaults different?
The process of liquidations for stable asset vaults is the same as the volatile asset vaults except that the liquidation bonus is 5% instead of 10% for the liquidator.
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