Liquidation Mechanics

Liquidation protects lenders from bad debt by seizing borrower collateral when positions become unsafe. Understanding liquidation mechanics helps borrowers avoid it and helps liquidators participate profitably.

When liquidation occurs

A position becomes liquidatable under two conditions:

Health factor below threshold - When collateral value drops relative to debt, the health factor falls. If it drops below the liquidation threshold, anyone can liquidate.

Loan expiration - When a loan passes its repayment deadline without being repaid, it becomes immediately liquidatable regardless of collateral value.

Health factor explained

The health factor measures how well-collateralized a position is:

healthFactor = (collateralValue * 10000) / totalDebt

The health factor is expressed in basis points. A value of 15000 means collateral is worth 150% of debt. As the ratio drops, the position becomes riskier.

Risk levels:

• 15000+ (150%+) - Safe position with significant buffer

• 11000-14999 (110-150%) - Warning zone, consider adding collateral

• Below liquidation threshold - Liquidatable

The liquidation threshold varies by loan. A typical threshold of 8500 bps (85% LTV) means liquidation triggers when collateral value falls to 117.6% of debt (10000/8500 = 1.176).

What moves health factor

Collateral price drops - If your collateral loses value, health decreases. A 10% price drop on a position at 130% health pushes it to around 117% health.

Interest accrual - Your debt grows over time. Even with stable collateral prices, accruing interest gradually reduces health.

Collateral price rises - Good news improves your health automatically.

Adding collateral - Top-ups directly improve health by increasing the numerator.

Partial repayment - Reduces debt, improving health by decreasing the denominator.

The liquidation process

When a position becomes liquidatable, the following happens:

1. The backend detects the position is below threshold or expired

2. The backend computes liquidation parameters - how much debt to repay and how much collateral to seize

3. The liquidation is included in the next epoch's Merkle tree

4. The epoch advances with the new liquidations root

5. A liquidator submits a Merkle proof to execute the liquidation

6. The liquidator pays the debt amount to the IssuedDebt contract

7. The liquidator receives seized collateral plus a bonus

Liquidation bonus

Liquidators receive a bonus for their service. A typical bonus of 500 bps (5%) means if a liquidator repays $1,000 of debt, they receive $1,050 worth of collateral.

The bonus incentivizes prompt liquidation. Without it, no one would spend gas to liquidate positions. The bonus comes from the borrower's collateral - it is part of why borrowers want to avoid liquidation.

Partial vs full liquidation

Partial liquidation occurs when the position can be restored to health by repaying a portion of debt. The liquidator repays enough to bring the health factor back above a target level (typically 120%).

Full liquidation occurs when the position is severely undercollateralized or expired. The entire debt is repaid and all remaining collateral is seized.

Partial liquidation example

Consider a position with:

• 1.0 WETH collateral at $2,800 = $2,800 value

• 2,600 USDC debt

• Health factor: 2800/2600 = 107.7%

• Liquidation threshold: 85% (triggers below 117.6% health)

A liquidator repays 1,300 USDC (50% of debt). They receive:

collateralSeized = (1300 / 2800) * 1.05 = 0.4875 WETH

After liquidation:

• Remaining collateral: 0.5125 WETH = $1,435

• Remaining debt: 1,300 USDC

• New health factor: 1435/1300 = 110.4%

The position is restored to a safer level.

Cross-chain liquidation

For loans where collateral and principal are on different chains:

1. Liquidation executes on the principal chain (where the IssuedDebt exists)

2. The liquidator pays debt on the principal chain

3. A storage proof of the liquidation is generated

4. The proof is submitted to the Facts Registry on the collateral chain

5. The CollateralManager releases collateral to the liquidator's designated address

Cross-chain liquidation has additional latency due to proof generation and verification across chains.

Default handling

When a loan expires without repayment, it enters default status. Default triggers automatic full liquidation:

1. The backend marks the loan as DEFAULTED

2. Full liquidation parameters are computed

3. Liquidation is included in the next epoch

4. All collateral is seized

There is no grace period. The expiration timestamp is a hard deadline. Plan repayments accordingly.

Bad debt scenarios

In extreme market conditions, collateral value can fall below debt value faster than liquidation can occur. This creates bad debt - debt that cannot be fully recovered from collateral.

When liquidation proceeds are insufficient:

• The debt contract receives less than full repayment

• Price per debt token falls below 1.0

• Lenders receive less than principal when redeeming

This risk is why lenders should only accept high-quality collateral and maintain conservative LTV limits.

Protecting your position

For borrowers

Monitor health regularly - Check your positions daily during volatile markets. Set up alerts if the frontend supports them.

Maintain safety buffer - Aim for at least 130-150% health. This gives you time to react before reaching liquidation.

Keep collateral ready - Have additional collateral in your wallet ready to top up quickly if needed.

Repay early - If you can repay before the deadline, do so. Waiting until the last moment risks technical issues preventing repayment.

Use stable collateral - More volatile collateral requires larger safety buffers. ETH is safer than smaller cap tokens.

For lenders

Accept quality collateral - Only accept assets with deep liquidity that can be liquidated efficiently.

Set conservative LTV - Lower maximum LTV means larger buffer before liquidation risk.

Diversify - Spread lending across multiple borrowers. One bad loan should not devastate your portfolio.

Monitor borrower health - Watch for positions approaching liquidation. You may want to sell debt tokens before a messy liquidation.

Liquidator incentives

Liquidation is permissionless. Anyone can execute liquidations and earn the bonus.

Profitability - Liquidators earn the bonus minus gas costs and any price slippage from selling seized collateral.

Competition - As Amish matures, expect competition among liquidators. MEV searchers and specialized bots will compete to capture liquidation opportunities.

Infrastructure - Successful liquidation requires monitoring positions, detecting liquidatable ones, having capital ready, and executing quickly.

Liquidation rules

Each loan has liquidation parameters stored in its record:

Liquidation threshold - The LTV at which liquidation triggers. 8500 bps (85%) is common.

Target health factor - The health level partial liquidation aims to restore. 12000 bps (120%) is typical.

Liquidation bonus - The premium paid to liquidators. 500 bps (5%) is standard.

These parameters are set when the loan is created and cannot change.

Impact on debt tokens

When liquidation occurs, the proceeds go to the IssuedDebt contract. This updates the price per token:

• If full debt is repaid, price per token reflects principal plus any paid interest

• If partial debt is repaid, price reflects only what was recovered

Lenders can redeem debt tokens at any time at the current price. After liquidation, redemption claims whatever was recovered.

Summary

Liquidation exists to protect lenders. It creates strong incentives for borrowers to maintain healthy positions. Understanding these mechanics helps all participants:

• Borrowers can avoid liquidation by maintaining buffers and adding collateral when needed

• Lenders can assess risk by understanding what happens when borrowers fail

• Liquidators can profit by efficiently processing unhealthy positions