Liquidations

What are liquidations and how do they work?

Liquidations serve as a mechanism for ensuring the solvency of the system. If the Individual Collateral Ratio (ICR) of a Collateralized Debt Position (CDP) falls below the Minimum Collateral Ratio (MCR) of 110% when in Normal Mode, or the Total Collateral Ratio (TCR) of 125% when in Recovery Mode, the CDP is said to be open for liquidation. At this point, the outstanding debt can be repaid by any market participant (liquidator) in exchange for some surplus collateral and a gas stipend as incentives, which are determined based on the conditions outlined in the following section.

To fully liquidate a CDP, the liquidator must obtain the total amount of eBTC owed by the CDP and pay it to the system, which is then burned. By fully liquidating a CDP, the position at risk is effectively closed, which results in an improvement of the system's TCR (Total Collateral Ratio).

Multiple CDPs can be liquidated simultaneously within the same transaction, provided that all of them have an ICR below the MCR (or the TCR during Recovery Mode).

eBTC liquidations flow under Normal Mode

Can a CDP be partially liquidated?

In the event that the debt associated with a liquidatable CDP is too large to be repaid in full, a liquidator may opt for a partial liquidation. However, it is important to note that for a partial liquidation to be allowed, the CDP must end up with more collateral than the minimum CDP size requirement of the system (which is set at 2 stETH).

Similarly to a full liquidation, partial liquidations will also receive an incentive in the form of the collateral asset according to the criteria in the section below.

What is the Grace Period?

As soon as the system goes into Recovery Mode, any user interaction (borrowing, adjusting or redeeming) or a manual call of CdpManagerStorage.notifyStartGracePeriod will trigger a 15 minutes period during which liquidations are blocked. This is known as the Grace Period.

It is advised for CDPs at risk of liquidation to take advantage of this time period to deposit more collateral or payback some of their debt in order to improve their ICR and avoid getting liquidated.

How am I compensated for liquidating a CDP?

Liquidators are compensated differently depending on the ICR at which the CDP is liquidated and on whether they execute a full or partial liquidation. Below is a breakdown of the liquidation incentives under these conditions.

Full Liquidation

Full liquidations incentives are determined by the following general formula:

$Liq Incentive = max(1.03, min(ICR, 1.1))+ Gas\:Stipend$

Where Gas Stipend is equal to 0.2 stETH.

The same logic can be better visualized, for different values of ICR, as follows:

ICR	Debt to Repay	Liquidator Incentive	Owner's Coll. Surplus	Outstanding Debt
>110% (Recovery Mode)	Full CDP's Debt	(Full CDP's Debt worth of Collateral * 110%) + Gas Stipend	Full Collateral of CDP - Liquidator Incentive	0
>103%, <=110%	Full CDP's Debt	Full CDP's Collateral + Gas Stipend	0	0
<103%	Full Coll. worth of Debt / 103%	Full CDP's Collateral + Gas Stipend	0	Full CDP's Debt - Repaid Amount

The table above demonstrates that eBTC's innovative incentives algorithm has been crafted to guarantee liquidation profitability in all cases, even where a CDP becomes undercollateralized. This is accomplished by offering a 3% collateral incentive to all CDPs with an ICR of 103% or less. However, it is important to note that this means that any full liquidation with an ICR below this threshold will result in the CDP having no collateral and a small amount of bad debt outstanding. The mechanism for handling this bad debt will be explained in the next section.

In summary, we can note that the max possible incentive for a full liquidation is 10% of the CDP's collateral + Gas Stipend and the min incentive possible is 3% of the CDP's collateral + Gas Stipend, regardless of the mode of operation. Moreover, readers should note that these bounds also apply for Recovery Mode liquidations; CDPs liquidated at a 125% ICR are also subject to a a maximum liquidation penalty of 10% and are able to claim any resulting collateral surplus.

Partial Liquidation

Partial liquidations incentives are determined by the following general formula:

$Liq Incentive = max(1.03, min(ICR, 1.1))$

As you can tell, this formula is basically the same as that of full liquidations, with the exception that partial liquidations do not include the additional Gas Stipend. This is because there is only one Gas Stipend allotted per CDP and it is reserved to incentivize full liquidations. Full liquidations lead to a more favorable outcome for the system, hence they are prioritized over partial liquidations.

The same logic can be better visualized, for different values of ICR, as follows:

ICR	Debt to Repay	Liquidator Incentive	Owner's Coll. Surplus	Outstanding Debt
>110% (RM)	Up to liquidator	Collateral worth of the partial debt repaid * 110%	Variable, must be at least 2 stETH	Variable
>103%, <=110%	Up to liquidator	Collateral worth of the partial debt repaid * ICR	Variable, must be at least 2 stETH	Variable
<103%	Up to liquidator	Collateral worth of the partial debt repaid * 103%	Variable, must be at least 2 stETH	Variable

As evident from the table above, partial liquidations are always incentivized, just like full liquidations. The CDP's ICR does not affect this incentivization. However, unlike full liquidations, partial liquidations do not include the Gas Stipend. Therefore, a liquidator must estimate the correct amount to liquidate and the corresponding ICR to properly subsidize their gas costs based on the incentives offered by the operation.

In summary, we can note that the max possible incentive for a partial liquidation is 10% of the CDP's collateral and the min incentive possible is 3% of the CDP's collateral, both proportional to liquidation size and regardless of the mode of operation.

How does the system handle bad debt?

Bad Debt Redistribution

As described in the section above, in the off case that a CDP is not liquidated until after its ICR goes below 103%, the system will allow for the depletion of its collateral in order to properly incentivize the liquidation operation at the cost of leaving some uncollateralized debt behind. The amount of Resulting Bad Debt from an undercollateralized liquidation can be estimated as follows:

$Resulting\:Bad\:Debt = Total\:Debt - Liquidatable\:Debt = Total\:Debt - \frac{Total\:Collateral}{103\%}$

$Resulting\:Bad\:Debt = Total\:Debt - \frac{ICR \times Price \times Total\:Debt}{103\%}$

Where ICR is the ratio at which the CDP is liquidated at, in order for it to result in bad debt it must fall below 103%. We can quickly see that there's a linear relation between the amount of Resulting Bad Debt and the ICR at which it was liquidated.

Relation between the ICR of an underwater liquidation and its resulting Bad Debt

Once an underwater CDP is liquidated to this point, the system will distribute the remaining bad debt among all open CDPs in the system in proportion to their collateral size. This means that the debt of each CDP will increase resulting in a proportional decrease to their ICRs. Debt redistribution happens atomically with the underwater liquidation, therefore it is triggered by this liquidator.

Bad Debt Redistribution may impact your ICR to the point that it makes it open for liquidation. It is advisable to maintain a safe margin above the MCR (or even the CCR).

Bad debt redistribution flow