Liquidators play a crucial role in maintaining the stability of a lending network and preventing defaults. They ensure that there is enough liquidity in the system to cover open positions. However, borrowers should exercise caution and take preventative measures to avoid being liquidated.

What happens if a loan gets liquidated

Liquidation is the act of repaying a borrower's loan on their behalf in the protocol for a fraction of their collateral. In a healthy lending network, liquidators are incentivized to regularly identify eligible loans for liquidation. This process involves monitoring the value of a position and determining when it has crossed the liquidation threshold. Once a signal is received indicating eligibility for liquidation, a liquidator steps in to repay a part of the loan on behalf of the borrower. The liquidator receives a share of the collateral corresponding to the amount they paid off, plus the Liquidation Incentive.

When does a position get liquidated?

A position may become eligible for liquidation when the collateral value falls below the value of the amount that has been borrowed. The Liquidation Factor is a percentage multiplier used to determine when liquidation may occur.

For instance, suppose a user deposits ETH with a Liquidation Factor of 80%. In that case, a liquidation can take place when the value of the borrowed position reaches 80% of the deposited ETH value.

What triggers a liquidation?

It is important to monitor a position's exposure to liquidation by paying attention to two price movements: the collateral token's value and the borrowed token's value. In the event that either of these values changes and moves the position closer to liquidation, it is necessary to adjust the loan accordingly.

For instance, if a user deposits 1 ETH as collateral when 1 ETH = $1000 USD, and uses it to borrow $400 DAI, and if the price of ETH falls to 1 ETH = $500, the new liquidation point becomes $400 (80% x $500). Similarly, if a user deposits $1000 DAI as collateral and uses it to borrow 0.5 ETH when 1 ETH = $1000 USD, and if the price of ETH rises to 1 ETH = $1500 USD, the position becomes eligible for liquidation as the value of the borrowed tokens increases to $750 USD (0.5 ETH x $1500 USD).

How much of a loan gets liquidated?

In USDFI's Money Markets, liquidations are limited to a maximum of 50% of a position's value (the Close Factor). This means that only a portion of the borrower's outstanding debt can be repaid during the liquidation process.

For instance, let's say you have a position where you deposited $1,000 worth of DAI and borrowed $400 worth of ETH, and it becomes eligible for liquidation. Assuming the Liquidation Incentive for DAI is 10%, a liquidator would repay up to $200 worth of ETH (50% of what you borrowed) on your behalf. In return, the liquidator would receive $220 worth of your DAI: $200 DAI + $20 DAI for the Liquidation Incentive.

After the liquidation, your new position would have a Deposit Value of $780 in DAI and a Borrow Value of $200 in ETH. You can find the Liquidation Incentives for each asset by clicking on the asset in the "Network" tab of the app.

Avoiding Liquidiations

To minimize the risk of liquidation, it's crucial to have a thorough understanding of how and when it can occur. Besides, you can take some steps to reduce the likelihood of liquidation.

  • One such measure is to avoid borrowing the maximum amount possible, which allows you to create a buffer between the Collateral Factor and the Liquidation Factor.

  • Using stablecoins for lending or borrowing can also decrease the chances of liquidation as the value of these tokens remains stable.

  • Regularly monitoring your position and having a repayment plan can help you avoid liquidation.

However, the best way to prevent liquidation is to ensure that the value of your collateral is significantly higher than the amount you've borrowed. If you're still at risk of liquidation despite following these tips, consider paying back a portion of your loan or depositing more collateral to reduce your loan-to-value ratio. Be aware that each form of collateral has its own Liquidation Factor, so using multiple types of collateral could impact your overall position.

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