How Liquidations Work
A liquidation event occurs when a borrower’s Health Factor reaches 0%—the point at which the borrower's position will be signaled for liquidation. This allows liquidators to seize the borrower’s collateral, sell it and pay off the outstanding debt whilst earning a liquidation fee.
Silo currently employs full-collateral liquidation. When a position is signaled for liquidation, a liquidator seizes ALL of the borrower’s collateral in order to pay off their borrow position. When the liquidation event is complete, the liquidated borrower is only left with what they have borrowed.
This liquidation method is suited for long-tail assets that may have limited liquidity and high slippage when liquidated.
Let's go through a worked example to see how liquidations work:
- You have $1,000 wstETH and want to borrow ETH.
- You deposit $1,000 wstETH and borrow $850 ETH which is the maximum amount you can borrow given the Max LTV (Max LTV = 85% = 850/1000).
Now let us pretend that the value of your ETH borrowing has increased to $910 whilst the value of your wstETH collateral has remained the same.
Given that the Liquidation Threshold of wstETH is 90% and your Health Factor has reached 0%, your position is signaled for liquidation.
When your position is signaled for liquidation the following happens:
- 1.A liquidator seizes your collateral ($1,000 wstETH)
- 2.The liquidator sells your collateral (wstETH) for your borrowed asset (ETH)
- 3.The liquidator repays your outstanding debt ($910 ETH) and keeps your remaining collateral ($90 wstETH)
- 4.As the borrower, you keep your borrowings ($910 ETH) but lose your collateral ($1000 wstETH)
- 5.The Liquidation Fee paid to the liquidator is 9.89% (Liquidator Reward/Outstanding Debt = 90/910)
This is to incentivize prompt liquidations of positions that exceed the Liquidation Threshold. If their debt positions were to grow beyond the value of their collateral this would lead to under-collateralization, which would result in bad debt accruing to that silo.
The Health Factor is a clear visualization of how your borrow position stands. It ranges from green (100%) to red (0%). When your Health Factor reaches 0%, your borrow position will be signalled for liquidation.
At any given time, the health factor of a borrow position is assigned a percentage based on the value of your Loan (in ETH), the value of your collateral (in ETH), and the Liquidation Threshold that is set for the asset you have borrowed.
This is the most important factor to consider when gauging how close you are to liquidation.
The Liquidation Threshold is the ratio of your total borrow (ETH value) divided by your collateral (ETH value) at which point your position can be signaled for liquidation.
In the above example, if your borrow-to-collateral ratio reaches 80%, your position can be liquidated.
The Maximum Liquidation Fee is given by [1 - Liquidation Threshold]. This amount is awarded to liquidators for prompt liquidations.
As a borrower’s borrow-to-collateral ratio increases beyond the liquidation threshold, the liquidation fee they receive decreases. The Liquidation Fee provides an incentive for liquidators to liquidate positions as soon as they are signaled for liquidation in order to prevent bad debt.