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.