How Does a Liquidation Mechanism Work in an Over-Collateralized System?
When the value of the deposited collateral drops, causing the collateralization ratio to fall below a predetermined minimum threshold, the liquidation mechanism is triggered. The system automatically sells the collateral on the open market or through a decentralized auction to cover the outstanding stablecoin debt plus a penalty fee.
This process protects the protocol's solvency by ensuring the debt is repaid before the collateral's value drops too low, thereby preventing the stablecoin from becoming under-collateralized.
Glossar
Decentralized Auction
Mechanism ⎊ Decentralized auctions, within cryptocurrency and derivatives markets, represent a shift from centralized exchange control to on-chain, programmatic price discovery.
Stablecoin Debt
Liability ⎊ Stablecoin debt represents a borrower's liability to repay a quantity of a cryptocurrency pegged to a stable reference asset, such as the US dollar.
Flash Loan Attack Vector
Exploit Vector ⎊ Flash Loan Attack Vector describes a vulnerability in DeFi protocols where an uncollateralized, instantaneous loan is used to manipulate asset prices on one exchange to profit from a related derivative or lending transaction on another, all within a single atomic transaction block.
Collateralization Ratio
MarginRequirement ⎊ The Collateralization Ratio quantifies the amount of posted margin relative to the notional value or exposure of a leveraged position, serving as the primary metric for assessing margin adequacy.
Liquidation Price
Trigger ⎊ The Liquidation Price is the specific market price level at which a trader's margin equity falls to the maintenance margin threshold, causing the exchange or protocol to automatically close the leveraged position to prevent the account balance from falling into negative territory.
Liquidation Mechanism
Mechanism ⎊ The liquidation mechanism, within cryptocurrency derivatives, options trading, and broader financial derivatives, represents a pre-defined process triggered when a trader's margin falls below a specified threshold, typically due to adverse price movements.