Liquidation
Basics
Opening a leveraged position involves borrowing crypto assets to increase your potential return. Doing so allows you to take advantage of market fluctuations and potentially achieve greater profits than if you had simply invested your own funds. However, it's important to be aware of the risk of liquidation.
When a position's debt-to-value ratio (Debt Ratio) exceeds a certain threshold (Liquidation Threshold), Liquidation occurs. This triggers ExtraFi’s liquidation bot to close the position to ensure debt repayment, which means your borrowed funds will be returned to the lender, and any potential remaining portion(after deductions of liquidation bounty) will be returned.
Formula
Debt Value: The value of the borrowed tokens
Position Value: The total value of your farming position, which is equal to Debt Value + Equity Value
Equity Value: Position Value - Debt Value
Parameters
Extra Finance liquidates farming positions at an 83.33% LTV ratio, which leaves about a 16.67% buffer to liquidate. For stable pools, the LTV threshold is 90.00%
(These parameters may be subject to updates in response to changes in market conditions and in accordance with governance procedures.)
Liquidation Example 1.0
Please read 'Safe Liquidation 2.0,' which is an enhanced mechanism working now designed to minimize position loss.
(the below process now serves as a backup solution for 'Safe Liquidation 2.0'.)
Bob chooses to farm in the ETH-USDC liquidity pool when the price of ETH is $2,000 and that of USDC is $1:
Bob opens an ETH-USDC leveraged farming position using 3x leverage
He supplies 10 ETH (worth 20,000 USDC), which is his initial Equity Value
He borrows 40,000 USDC (2x what he supplied, when combined with the 20,000 he added himself, that makes 3x total)
The protocol then automatically converts all deposited and borrowed tokens into a 50:50 proportion for creating the LP tokens for farming: 15 ETH + 30,000 USDC, which is his initial Position Value. (Due to the price impact from swapping and trading fees, it would be slightly lower in reality)
Bob’s Debt Ratio (Debt / Position Value) is ~66% (40,000 USDC / 60,000 USDC)
If the ETH price drops > 36%, then Bob’s Debt Ratio will exceed 83.3% (the Liquidation Threshold for the ETH-USDC pool). It will trigger the liquidation bot to close his position, repay the debt, and return any potential remaining assets (after deductions of liquidation bounty).
Please note that the example above did not consider the impact of yield farming rewards and trading fees.
Safe Liquidation 2.0
In our ongoing efforts to minimize price impact and protect user assets during liquidation events, we introduce Safe Liquidation 2.0. This mechanism is designed to enhance user security and is outlined as follows:
Partial Liquidation: When the Liquidation Threshold is reached, only a portion (typically 30%, more details here) of the user's position will be subject to liquidation.
Debt Repayment: During the liquidation process, after accounting for liquidation bounties, all the potential remaining portion of the position to be liquidated will be utilized to repay the debt. This ensures that users maintain a safer debt ratio for the remaining part of their position.
User Asset Safety: If liquidation continues due to ongoing price movements, users may eventually retain LP assets on the platform, free from leverage. These assets represent the remaining portion of the position post-liquidation, and they can be withdrawn at any time.
Advantages of Safe Liquidation 2.0
Reduced Risk of Total Position Liquidation: Safe Liquidation 2.0 mitigates the risk of completely liquidating a position. By utilizing partial liquidation, it repays part of the debt, effectively lowering the debt ratio of the position. This process enhances the likelihood of averting additional liquidations, thereby increasing the safety of the assets held.
Prevention of Circular Liquidation: Comprehensive liquidation of large-value positions can adversely affect market prices within the liquidity pool, potentially triggering a domino effect of further liquidations. Safe Liquidation 2.0 addresses this issue by limiting the liquidation extent, thereby safeguarding the user's position and reducing the risk of such recursive liquidation scenarios.
Decreased Liquidation Fees: The fee structure of Safe Liquidation 2.0 is more favorable compared to traditional methods. It charges an 8% fee on the value of the liquidated portion of the position. Since it targets 30% of the total position value for liquidation, the effective fee is 2.4% of the total position value. This is significantly lower than the typical 5% liquidation fee on the entire position value, thus saving costs for users during the liquidation event.
Safe Liquidation 2.0 Example
Let's consider Bob, who has a position to be liquidated. To illustrate the optimization of his position assets and liquidation fees with Safe Liquidation 2.0, we'll compare two scenarios: one under the Liquidation Mechanism 1.0 and the other under Safe Liquidation 2.0.
Scenario 1: Liquidation Mechanism 1.0
Bob’s position value: $100,000.
Due to market volatility, his position becomes subject to liquidation.
Under the current mechanism, there's a possibility of complete liquidation.
Liquidation Fee: 5% of the total position value.
Bob pays a liquidation fee of $5,000 ($100,000 * 5%).
His entire position is liquidated.
Scenario 2: Safe Liquidation 2.0
Bob’s position value remains at $100,000.
His position again becomes subject to liquidation due to market changes.
Under Safe Liquidation 2.0, only a portion of his position is liquidated (let's say 30% for this example).
Liquidated Position Value: $30,000 ($100,000 * 30%).
Liquidation Fee: 8% on the liquidated portion.
Bob pays a liquidation fee of $2,400 ($30,000 * 8%).
Only $30,000 of his position is liquidated. The remaining from this partial liquidation (excluding the liquidation fee) is used to repay a portion of Bob’s debt, thereby effectively reducing his overall debt. With lower outstanding debt, the debt ratio of the remaining 70% of Bob's position (valued at $70,000) declines! This makes his position less vulnerable to further market downturns and potential liquidations.
Comparison and Benefits:
Reduced Liquidation Fee: In Scenario 2, Bob pays $2,400, which is significantly less than the $5,000 fee in Scenario 1.
Asset Preservation: Bob retains 70% of his position under Safe Liquidation 2.0, unlike complete liquidation in the previous mechanism.
Risk Mitigation: Safe Liquidation 2.0 reduces the risk of triggering further liquidations in the market, which could be caused by the price impact of large-scale liquidations.
⚠️ Important: Please note that in the event of a significant price movement, there is a possibility that no remaining assets are left. This can occur when the equity approaches the value of the debt or falls below the value of the debt, leading to a complete loss of assets.
Liquidation Price Oracle
Liquidation triggers are based on the on-chain Time Weighted Average Price (TWAP) calculated over a 30-minute period.
By utilizing TWAP, the system ensures that positions are more resilient and better protected, particularly in highly volatile markets. This safeguard is designed to shield leverage farmers from sudden price fluctuations or malicious manipulations, reducing the risk of flash liquidation events.
Liquidation Bot
The team will initially run the liquidation bot to make sure that the market is orderly during the launch phase. This will help ensure that positions are being liquidated in a timely manner, which will in turn help to prevent any potential issues or complications. Additionally, the sample code for the liquidation bot will be open-source in the future.
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