Dynamic Liquidation 101
TL;DR: Superposition’s Dynamic Liquidation
Let’s talk about one of the key features of using Superposition: Dynamic Liquidation.
Liquidation close-out ratio is defined as the percentage of total collateral being liquidated when a user’s Health Ratio drops below the required threshold. The close-out ratio is the metric that determines liquidations on the user’s portfolio during volatile times.
Superposition is built on Concordia infrastructure and leverages Concordia’s dynamic liquidation engine to determine optimal liquidation close-out ratios. Superposition dynamically adapts close-out ratios based on market conditions to safeguard users against a potential domino liquidation scenario, reinforcing that Superposition’s optimized, data driven risk management practices provide unparalleled protection for users of the protocol.
Diving in Deeper, Let’s get Technical
Lending protocols allow users to withdraw overcollateralized loans with very low interest rates. However, due to accrued interest or currency fluctuations, these positions may become unhealthy. If this occurs, the user’s position becomes eligible for liquidation, meaning another user can offer to pay back part of the debt to earn a liquidation bonus paid by the user who was liquidated.
In lending protocols, the status of user loans is monitored via a Health Ratio, or a ratio of collateral to amount borrowed. A safe Health Ratio is indicated by a ratio that is one or above, as shown by the equation below. A position with a low Health Ratio may be liquidated to maintain solvency. The Health Ratio is calculated by the protocol as follows:
When a user’s Health Ratio drops below 1, the loan becomes eligible for a liquidation event. Typical lending protocols adopt a fixed close-out ratio of 25% or 50%. However, this results in the protocol liquidating more collaterals than necessary in moderate volatility environments and less collaterals than necessary in high volatility environments.
SCENARIO ONE: Fixed Liquidation Close-Out Ratio Is Not Efficient During Moderate Volatility
Time One: A user initiates a portfolio and borrowing position on a lending protocol
Time Two: Market turbulence causes APT to drop 12% (moderate volatility)
As a result, a fixed 50% liquidation was triggered at 50% close out ratio.
Liquidation 1 @ 50% close-out ratio
However, a mere 25% close-out ratio could have made the portfolio healthy, avoiding extra fees paid in the above scenario.
Liquidation 1 @25% Close-out ratio
SCENARIO TWO: Fixed Liquidation Close-Out Ratio Causes Deteriorating Liquidations During High Volatility
Time One: A user initiates a portfolio and borrowing position on a lending protocol
Time Two: Market turbulence causes APT to drop 18% (high volatility)
Since the Health Ratio drops below the required 1.2 threshold, a fixed 50% liquidation was triggered at 50% close out ratio.
Liquidation 1 at a 50% close-out ratio:
While the health ratio has increased, it is still below the required 1.2 threshold. Therefore, another fixed 50% liquidation was triggered at 50% close out ratio.
Liquidation 2 at a 50% close-out ratio
Notice the user’s portfolio health ratio actually deteriorates after the 2nd liquidation. This initiated a downward spiral that causes follow-up liquidations to occur until the entire portfolio is liquidated. During this period, volatility and market liquidity fluctuations may prevent further liquidations, leaving lenders and the protocols with bad debt that can no longer be recovered.
SCENARIO THREE: Superposition Adopts Dynamic Liquidation Close-Out Ratio to Achieve Optimal Risk Management
Instead of relying on a fixed close-out ratio to combat against dynamic and unpredictable markets, Superposition adopts a data-driven approach in determining the close-out ratio depending on the market condition.
Superposition, by leveraging Concordia’s Modular Risk Engine, determines the optimal close-out ratio based on simulated outcomes of the user’s collateral portfolio. In doing so, Superposition takes the “just right” amount of collateral when liquidating during moderate volatility and stops deteriorating liquidations on a borrower’s portfolio during high volatility.
Time One: A user initiates a portfolio and borrowing position on a lending protocol
Time Two: Market turbulence causes APT to drop 12% (moderate volatility), and Superposition’s simulation reveals that a 25% liquidation would bring the portfolio back to healthy status. Therefore, only 25% of the portfolio is liquidated.
Liquidation at a 25% Close-out ratio
Time Three: Swapping the above to illustrate a high volatility scenario — in T3, market turbulence causes APT to drop 18% (high volatility) instead. In this case, Superposition runs simulation with Concordia’s liquidation engine and determines that a swift 75% liquidation is warranted to bring the portfolio back to healthy status.
Liquidation at a 75% close-out ratio
This avoids cascading liquidations that ultimately clear out the user’s portfolio.
