Money Market Liquidation
Introduction
A liquidation is a process that occurs when a borrower's health factor goes below 1 due to their collateral value not properly covering their debt value. This might happen when the collateral decreases in value or the borrowed debt increases in value against each other. This collateral vs loan value ratio is shown in the health factor:
When Hf<1, the position may be liquidated.
In a liquidation, up to 50% of a borrower's debt is repaid and that value + liquidation fee is taken from the collateral available, so after a liquidation the amount liquidated from your debt is repaid.
How much is the liquidation penalty?
The liquidation penalty (or bonus for liquidators) depends on the asset used as collateral.
Can you give me an example?
Example 1: User A deposits 10 ETH and borrows 5 ETH worth of DAI. If User A's Health Factor drops below 1, their loan will be eligible for liquidation. A liquidator can repay up to 50% of a single borrowed amount (2.5 ETH worth of DAI). In return, the liquidator can claim a single collateral which is ETH. The liquidator claims (2.5 + liquidation bonus) ETH for repaying 2.5 ETH worth of DAI, profiting from the liquidation bonus.
Example 2: User B deposits 5 ETH and 4 ETH worth of WMNT, and borrows 5 ETH worth of DAI. If User B's Health Factor drops below 1, their loan will be eligible for liquidation. A liquidator can repay up to 50% of a single borrowed amount (2.5 ETH worth of DAI). In return, the liquidator can claim a single collateral. If the liquidation bonus is higher for WMNT than ETH, the liquidator may choose to claim WMNT. The liquidator claims (2.5 + liquidation bonus) ETH worth of MNT for repaying 2.5 ETH worth of DAI.
How can I avoid getting liquidated?
To avoid liquidation you can raise your health factor by depositing more collateral assets or repaying part of your loan. By default, repayments increase your health factor more than deposits. Also, it's important to monitor your health factor and keep it high to avoid a liquidation. Keeping your health factor over 2, for example, gives you more of a margin to avoid a liquidation. You should be mindful of stablecoin price fluctuations due to market conditions and how it might affect your health factor. For example, the market price of 1.00 USDC might not equal exactly 1.00 USD, but for example 0.98 USD. The price fluctuations of stablecoins, like any assets, affects your health factor.
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