BakerDAO Explanation II: Liquidation (August 6, 2021)
Friday, August 6, 2021
What is liquidation?
BakerDAO's Vault may be liquidated when it is deemed unsafe. This ensures that there is sufficient collateral in the system to support the value of all issued BAIs. Liquidation occurs when the total value of the collateral in the Vault (judged by the data from the oracle machine) is less than the required collateral value for the asset type. During the liquidation process, collateral sufficient to cover the debts and expenses is deducted, and users can retrieve the remaining.
Why is liquidation needed?
Unlike most fiat currencies that have value only endorsed by government decree, BAI is a modern, cryptographically secure currency; excess collateral tokens exist for all BAIs in circulation and are stored in smart contracts as value reserves, thereby ensuring de-trust and eliminating counterparty risk. This is a completely transparent mechanism, which allows users to maintain confidence in the system.
Who can trigger liquidation?
To ensure that excess collateral is available at all times, users called Keepers maintain monitoring of insecure or under-collateralized Vaults. These Keepers are a special group of users in the BAI stablecoin system. They are motivated by the system to ensure that the issued BAIs are fully collateralized and refundable, and maintain the health of the entire ecosystem by liquidating insecure Vaults as quickly as possible. This is especially important when the market declines rapidly, because the value of the collateral may not cover the debts.
What is the liquidation ratio?
Each type of collateral has a unique liquidation ratio, which is determined by the risk profile of that particular asset type. The current collateral types include BNB, ETH, BTCB, and BUSD.
When the system was launched, the BakerDAO team evaluated the risk profile of each asset type and determined that the appropriate liquidation ratio was 150% for ETH, 175% for BNB, 150% for BTCB, and 101% for BUSD.
The system uses the Chainlink oracle machine to provide price data to calculate when the collateral ratio of a given Vault falls below the liquidation ratio. The liquidation ratio is determined by the combination of the risk profile and the market price given by the oracle machine.
For example, a user wants to withdraw 200 BAIs and believes that the value of the collateral will not fall below 50% of its current market price. The user decides to collateralize assets at least twice the minimum collateral limit. Since the minimum collateral limit is 150%, the user deposits USD600 worth of ETH and withdraws 200 BAIs so that 300% collateral is kept in the Vault.
Note: 150% is the minimum ratio at which Vaults collateralized with ETH allow collateralization before they are liquidated by the Keeper. Staying above this bottom line will prevent the user's collateral from being liquidated.
What is the liquidation price?
The liquidation price is the lowest price before the Vault can be liquidated.
What is the liquidation penalty?
This is the fee added to the total outstanding BAI debt at the time of liquidation and is deducted from the collateral in the Vault.
What happens during the liquidation process?
Liquidation begins when the Keeper triggers the liquidatable Vault and sends it to the liquidity providing contract, and the assets in the Vault will be sold on the BAI panel. Once the debt to be repurchased has been sold, the unsold collateral will be returned to the Vault owner.
How much collateral will be left after liquidation?
To figure out how much collateral you still have after liquidation, the following simplified formula can be used:
(Collateral x price given by the oracle machine x PETH/ETH ratio) - (liquidation penalty x stability debt) - stability debt = (remaining collateral x price given by the oracle machine) BAI
Suppose that:
the ETH feed price given by the oracle machine is USD 350,
the total number of PETH locked is 10 ETHs,
the PETH/ETH ratio is 1.012,
the liquidation penalty is 13%, and
the stability debt of the Vault is 1,000 BAIs,
then (10 × 350 × 1.012) - (13% × 1000 -1000 = 2412 BAIs or 6.891428571 ETHs.
How can I calculate the liquidation price?
The following simplified formula can be used to determine the point at which the value of the collateral triggers liquidation:
(Stability debt x liquidation ratio) / (collateral x PETH/ETH ratio) = liquidation price
For example,
if the price of ETH is USD 350,
the total number of collateralized PETH is 12,
the PETH/ETH ratio is 1.012,
the liquidation ratio is 150%, and
the stability debt is 1,000 BAIs,
then (1000×1.5) ÷ (12×1.012) = USD 123.51.
When the ETH price falls to USD 123.51, the Vault will be deemed as insecure and face the risk of being liquidated.
How can I calculate my collateral ratio?
If you want to determine the health of your debt by checking your collateral-to-debt ratio (rather than the liquidation price), you may use the following simplified formula:
(Number of PETH locked × ETH price × PETH/ETH ratio) ÷ stability debt × 100 = collateral ratio
For example,
if the price of ETH is USD 350,
the total number of collateralized PETH is 12,
the PETH/ETH ratio is 1.012, and
the stability debt is 1,000 BAIs,
then (12×350×1.012) ÷ 1000×100 = 425.04%.
The collateral ratio of the Vault is 425.04%.
How can I lower down my liquidation price?
The main challenge for Vault owners is to maintain a safe leverage position in a highly unpredictable market. If your Vault is close to the liquidation price, you may increase collateral or repay BAI to reduce the risk.
Which approach you choose depends on your long-term goals. If you firmly believe in the future value of the underlying collateral, you may increase collateral. Alternatively, if you want to bring down the risk of price fluctuations, you can pay the debt by returning BAI to the vault.
The best way to reduce liquidation risk is to repay BAI, which can not only lower the liquidation price more effectively, but also reduce the stability fee incurred by the Vault.
Suppose that:
if the price of ETH is USD 350,
the total number of collateralized PETH is 12,
the PETH/ETH ratio is 1.012,
the liquidation ratio is 150%, and
the stability debt is 1,000 BAIs,
then the current liquidation price is:
(1000×1.5) ÷ (12×1.012) = USD 123.51
Change in liquidation price after adding USD 700 of collateral:
(1000 x 1.5) ÷ (14 x 1.012) = USD 105.87
Change in liquidation price after reducing USD 700 of debt:
(300 × 1.5) ÷ (12 × 1.012) = USD 37.05
It can be seen that returning BAI reduces the liquidation price more significantly than adding collateral.
General practices to avoid being liquidated
It is your responsibility to keep an eye on the health of your Vault. This is to ensure that assets are not liquidated and are completely in the hands of each Vault owner. Here are some common practices for monitoring the health of your Vault:
setting alerts of changes in collateral price in the App; and
ensuring that you hold sufficient assets by adding collateral or selling these assets for BAI to pay debts and make up for your position.
If you think the market may continue to go down, you may withdraw the excess collateral from the Vault, sell it for BAI, and then use BAI to pay your debt. (Be sure to keep a safe margin from the liquidation price, as this strategy will temporarily put the Vault in a riskier position until the debt is settled with BAI.) )
Remember that creating a Vault l also brings risks. How much risk an investor would like to take depends on many factors. Determining the risk profile is a science in itself, but every Vault owner needs to master such knowledge.
For more information on risks, see the Terms of Service, which provide important legal information. Each Vault owner needs to confirm the Terms of Service before using the BAI stablecoin system.
How shall I sell the collateral through smart contracts?
When a Keeper liquidates an unsecured Vault, the liquidity providing contract (LPC) ensures that the collateral is sold on the BAI interaction panel. The selling price is determined by the price fed by the oracle machine. Collateral is usually sold at a discount, and the proceeds from the sale are then used to pay the outstanding debt that must be repurchased. "Discount" is given to encourage the system to quickly repurchase debts by providing collateral at a better price than the market price to the liquidator.
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