Liquidation is the process of selling off the borrower's collateralized assets to cover his/her outstanding Borrow Balance when the value of the collateralized asset can no longer maintain the appropriate ratio with the outstanding debt. It is the key mechanism that protects lenders from bad debt. Below, we discuss how liquidation is carried out at xBank.
To fully understand the liquidation process, you should first familiarize yourself with the following terms:
- 1.Collateralized Asset: This is the deposit that the borrower puts up as collateral. When liquidation is initiated, part of the collateralized asset will be sold to cover a portion of the outstanding Borrow Balance.
- 2.Collateral Factor (LTV): This is the ratio that determines borrow limit relative to the value of your collateralized asset. For example, if the Collateral Factor for ETH is 0.825, then the maximum loan size (Borrow Limit) that you can take out is 82.5% of the value of your collateralized ETH. Note that the Collateral Factor also acts as the liquidation threshold. If your Borrow Limit is more than or equal to your Collateralized Asset multiplied by its Collateral Factor, then you run the risk of being liquidated. You can find the Collateral Factor for assets at xBank here.
- 3.Borrow Limit: This is the maximum value of asset that you owe to xBank (Borrow Amount + Interest), as determined by the value of your collateralized asset multiplied by the collateralized asset's Collateral Factor. The Borrow Limit is also displayed in percentage at the top of your dashboard as a function of Debt Balance divided by Borrow Limit. Once your Borrow Limit hits 100%, meaning your debt balance reaches your Borrow Limit, you run the risk of being liquidated.
- 4.Borrow Balance: This is the balance of the outstanding debt (including accrued interest) that you currently owe to xBank.
- 5.Shortfall: A shortfall occurs when a user's Borrow Balance exceeds his/her Borrow Limit, and is the difference between the two values. When a shortfall occurs, your account runs the risk of liquidation.
- 6.Close Factor: The close factor determines the maximum percentage of your Collateralized Asset that could be liquidated in a single transaction. The Close Factor is currently set at 50% to limit potential Liquidation Penalty incurred on the position owner. To put it another way, a liquidator can liquidate up to 50% of your position in a transaction. If after liquidation, your remaining position is brought back within the safety parameters, it's safe from further liquidation.
- 7.Liquidation Penalty: This is the penalty charged on the borrower's collateralized asset when his/her account is liquidated.
To illustrate how liquidation is executed, let’s take a look at the example of Chris below:
On the 1st of March, Chris deposited 1 BTC into the lending vault and put it up as collateral to borrow 20,000 USDT. Below are the parameters of Chris' debt position:
- Collateralized Asset: 1 BTC (Assume 1 BTC = $50,000)
- BTC Collateral Factor (LTV): 0.80
- Chris' Borrow Limit: $40,000 ($50,000 * 0.80)
- Chris' Borrow Balance: 24,000 USDT (Assume 1 USDT = $1)
Sometime later, the market crashed and BTC price dropped to $29,000, causing Chris' collateral value to drop and his Borrow Balance to exceed his Borrow Limit. Below are the specifics on Chris' position as of then:
(We ignore borrowing interest in this example for simplicity)
- Collateralized Asset: 1 BTC (1 BTC = $29,000)
- BTC Collateral Factor (LTV): 0.80
- Chris' Borrow Limit: $23,200 ($29,000 * 0.80)
- Borrow Balance: 24,000 USDT (Assume 1 USDT = $1)
- Shortfall: -$800 ($23,200 - $24,000)
Now that Chris' Borrow Balance ($24,000) exceeds his Borrow Limit ($23,200), Chris' collateralized asset is now subject to liquidation. The liquidator then performs liquidation on Chris' collateralized asset.
- Close Factor: 50%
- Repayable Debt: 12,000 USDT ($24,000 * 50%)
- Liquidator to repay: 12,000 USDT
- Liquidation Penalty: 5%
- Collateralized Asset to be given to liquidator: ~0.434 BTC (($12,000 * 1.05) / $29,000)
- Chris' Remaining Collateralized Asset: ~0.566 BTC (1 BTC - 0.434 BTC)
- Chris' Updated Borrow Balance: 12,000 USDT (24,000 USDT - 12,000 USDT paid by the Liquidator)
- Chris' Updated Borrow Limit: $13,120 (0.566 BTC * $29,000 * 0.80)
- Shortfall: No Shortfall ($13,120 - $12,000 ≥ 0)
As you can see in the example above, after the liquidation event, Chris's remaining position now falls within the safety parameter and no additional liquidation can happen. However, if BTC price were to fall further, a new shortfall will likely occur which could trigger another liquidation transaction. In this scenario, Chris should either 1) Deposit more collateral or 2) Repay debt to make his position safer.