Liquidation

Liquidation Risk

What exactly is liquidation? Well, when you decide to open a leveraged position, essentially borrowing up to six times the funds you initially put in, the protocol needs to ensure you can repay that loan. The amount you initially contribute from your funds serves as collateral, which grows as you accumulate yields (minus the borrowing interest).

Now, here's the crucial part: that collateral must always remain greater than the amount you owe, plus a safety margin to account for rapid price fluctuations. If it doesn't, the protocol may step in and close your position to repay the lenders, a process known as liquidation. Liquidation isn't something you want to experience because, at that point, a percentage (see pool pages per Dex) of your remaining position value goes to the liquidator bot as compensation for ensuring lenders are repaid and your position is closed.

However, it's important to clarify that liquidation is a risk, but it's not a constant threat. When you initially open a position, you generally don't need to worry about it.

So when should you be concerned about liquidation? Well, since you've deposited cryptocurrencies, the value of your collateral is subject to market volatility and can change as token prices fluctuate. Furthermore, when you borrow funds, you essentially hold those assets and bear the potential gains (as well as losses) while your position is open.

It's worth noting that another term for your collateral is Equity Value, and this equity value must stay above a specific threshold to avoid liquidation. Specifically, if your Debt Ratio exceeds a limit known as the Liquidation Threshold, your position might be at risk of liquidation by a liquidation bot. This means the bot would step in, close your position, settle the debt, and return the remaining amount to you (usually in the borrowed tokens).

Why does liquidation occur at the Liquidation Threshold? Because at that point, your collateral (equity value) has dwindled to a level where there's a potential risk that you won't be able to repay your loan if the collateral's value keeps dropping. Liquidation is a necessary safeguard to protect lenders and instills confidence in them to lend their assets to you for profitable farming.

So, that's a general overview of liquidation. However, as leveraged farmers and investors, our primary concern is asset prices. Let's delve into that next, putting liquidation into perspective concerning asset prices.

Impact of token prices on liquidation risk

Let's say you open a leveraged yield farming position with $7,500 in ETH as collateral, borrowing $5,000 in stablecoins to farm liquidity pairs (LPs). Your initial position is $6,000. If the price of ETH drops significantly, the value of your collateral decreases. For example, if ETH drops by 20%, your $7,500 collateral is now worth $6,000.

If the value of your collateral falls below the required threshold, your position risks liquidation. Suppose the liquidation threshold is 85% ($5,100 in this example), meaning your debt ratio must stay below this level. With a falling ETH price, your equity value (collateral) might drop faster than your accumulated yields, pushing your debt ratio above 85%. At this point, the liquidation bot would step in, close your position, repay the loan, and return any remaining assets to you, minus a 5% liquidation fee.

This scenario highlights the importance of monitoring asset prices and understanding the risks associated with leveraged positions in volatile markets.