Liquidation Mechanism

The Liquidation Mechanism is used to protect the rights and interests of the lenders and the stability of the protocol. It is fully on-chain, decentralized, and public with incentives. Liquidation is categorized as Full Liquidation and Half Liquidation based on the value of the collateral.

Liquidation Threshold

The Liquidation Threshold is the maximum acceptable LTV ratio for a loan during its lifetime. If the LTV ratio of a loan reaches the Liquidation Threshold, the liquidation process can be executed by any liquidator with incentives. The Liquidation Threshold can vary depending on the collateral and borrowing token used in the loan.

The Liquidation Threshold is 0.8 for a non Stablecoin-Pair Loan, a loan with any non-stablecoin being a collateral or borrowed token while the ratio is 0.925 for the Stablecoin-Pair Loan, a loan with both collateral and borrowed tokens being stablecoins.

Fully On-chain Liquidation

If the LTV ratio of a loan reaches the Liquidation Threshold, the liquidation process can be executed by any liquidator with incentives. This process is fully on-chain, using the Chainlink oracle to define the current prices of the assets involved in the loan. For loans that involve LRTs and LSTs as collateral, we rely on price feeds from RedStone (https://redstone.finance/) oracle.

When liquidation is executed, the liquidator repays the debt on behalf of the borrower and takes the borrower's equivalent collateral along with an additional incentive of 5% (3% for Stablecoin-Pair Loan) of the debt value. When liquidation is executed, the loan record will be updated. The processes of Full Liquidation and Half Liquidation are illustrated in more detail in the relevant sections.

After the liquidation is executed and the liquidator takes the borrower's collateral and incentive, the remaining collateral (if any) is still staked in Term Structure, waiting to be claimed by the borrower.

Decentralized and Public Process

Since the liquidation is fully on-chain, anyone can execute liquidation by calling the liquidate function in a smart contract to maintain the stability of the whole system.

Incentive and Penalty

Incentive

In a decentralized protocol, incentives are often necessary to ensure the stable and continuous operation of the system. In the Term Structure ecosystem, liquidators play a crucial role in maintaining the stability of the system. They help to liquidate loans with unhealthy high LTV ratios, protecting the rights and interests of lenders, and they are rewarded with incentives for their efforts.

In each liquidation event, the liquidator will repay the debt for borrowers and receive an extra 5% worth of collateral as an incentive. (3% for Stablecoin-Pair Loan)

Penalty

In addition to providing incentives to liquidators, the protocol also applies a penalty of 5% (1.5% for the Stablecoin-Pair Loan) to borrowers whose debts are liquidated. This penalty is used to maintain the stability of the protocol and reduce the risk of bad debts. By imposing this penalty, the protocol encourages borrowers to manage their loans responsibly and avoid the risk of liquidation.

When liquidation is triggered, the borrower will lose at least 10% of the value of the debt in the form of collateral tokens for a non Stablecoin-Pair Loan. This is the result of the liquidator's incentive (5%) and the penalty applied by the protocol (5%).

For a Stablecoin-Pair Loan, the borrower will lose at least 4.5% of the value of the debt in the form of collateral tokens. This is the result of the liquidator's incentive (3%) and the penalty applied by the protocol (1.5%).

Full Liquidation

Liquidation is triggered when the value of the collateral drops to a certain threshold level, typically as a result of market movements. To protect borrowers from excessive losses due to liquidation, the protocol offers two types of liquidation processes: Full Liquidation and Half Liquidation. Full liquidation applies when the value of the collateral is no more than 10,000 in USD, while half liquidation applies in all other cases.

For example, let's consider a scenario where Alice has a loan on Term Structure, with ETH as collateral and DAI as the borrowed token. The initial value of the ETH collateral is USD20,000, and the value of the debt is USD8,000. If the value of ETH drops by 55% in the market and Alice does not add additional collateral, the value of the ETH collateral will decrease to USD9,000. Since the LTV Ratio is now equal to 0.89 , which is above the liquidation threshold of 0.8, and the healthy factor is less then 1.0, the liquidation process will be triggered.

The liquidator will pay all the debt of USD8,000 in DAI, and will receive the ETH collateral with a value of USD8,400 = (8,000 * (1 + 5%)). At the same time, the protocol will apply a penalty of 5% of the DAI debt equivalent of ETH.

Once the Full Liquidation process is completed, the borrower's debt will have been fully repaid. The borrower will have also paid the liquidator's incentives (5% of the debt) and the protocol's penalty (5% of the debt) in collateral tokens. The remaining collateral will be held in the smart contract, waiting to be claimed by the borrower.

When the value of the collateral is greater than USD 10,000, the liquidator is not able to execute Full Liquidation, even if the LTV Ratio reaches the Liquidation Threshold. In the scenario that the borrower does not repay before UTC 00:00 on the maturity date, the Full Liquidation applies, too.

Half Liquidation

Half Liquidation can be executed when the LTV Ratio reaches the Liquidation Threshold and the value of the collateral is greater than USD10,000. The purpose of Half Liquidation is to minimize the losses for borrowers while still protecting the rights of lenders and the stability of the protocol. After Half Liquidation is executed, the LTV of the loan will be reduced to a safe level, and if the value of the collateral continues to drop due to market movements, further liquidation may be triggered.

For example, let's consider a scenario where Alice has a loan on Term Structure, with ETH as collateral and DAI as the borrowed token. The initial value of the ETH collateral is USD600,000, and the value of the debt is USD240,000. If the value of ETH drops by 50% in the market and Alice does not add additional collateral, the value of the ETH collateral will decrease to USD300,000. Since the LTV Ratio is now equal to 0.8, the liquidation process will be triggered.

The liquidator will pay half of the debt of DAI, which is equivalent to USD120,000, and will receive the ETH collateral with a value of USD126,000 = (120,000 + ( 1 + 5%)), which includes the liquidator's incentive of 5% of the value of the debt. At the same time, the protocol will apply a penalty of 5% of the value of the debt in DAI, which will be paid in ETH.

After the Half Liquidation is completed, half of the borrower's debt will have been repaid. The borrower will have also paid the liquidator's incentive (5% of the repaid debt amount) and the protocol's penalty (5% of the repaid debt amount) in collateral tokens. In this case, the borrower will have an outstanding debt of USD120,000 in DAI and an ETH collateral amount of 300,000 - 126,000 - 6,000 = USD168,000. The LTV Ratio will now be 120,000/168,000 ~=0.714, which is below the Liquidation Threshold, and the loan record will be updated to reflect the new loan status. This means that the borrower will not be liquidated further unless ETH drops further to make the LTV Ratio greater than 0.8 again.

Half Liquidation cannot be executed when the LTV Ratio is triggered but the collateral value is less than 10,000 in USD.