Liquidating a loan position based on bad health

What are Liquidations?

Liquidations serve as a critical safety mechanism for crypto lending markets like those on Keom, ensuring markets remain solvent. In essence, if the value of collateral securing a loan declines and crosses below a critical threshold—indicated by the Health Factor (HF) - falling under 1—a portion of the loan is automatically sold off. This action is taken to settle a part of the outstanding debt and to restore the collateral ratio to an acceptable level.

This process contrasts with undercollateralised loans that rely on creditworthiness and the borrower's promise to repay. Overcollateralised lending models, such as those used by AAVE and Keom, minimise reliance on trust by using collateral that exceeds the value of loans.

Liquidation is a built-in security feature that activates when loans approach insolvency, replacing the need for traditional credit checks and mitigating the consequences of broken trust.

Liquidations are a necessary mechanism for the markets to stay solvent.

Liquidators are pivotal in maintaining the solvency of the lending system by executing liquidations when necessary. They are motivated to perform this task through a system of financial incentives. Here’s how it works:

  1. Liquidators bring in external funds to repay a portion of the at-risk loan. The maximum amount that can be repaid: ($) Max Repayment = ($) Debt * (%) Close Factor

  2. Upon repayment, liquidators earn a Liquidation Incentive. This incentive is a percentage of the repaid amount: ($) Liquidation Incentive = ($) Repaid amount * (%) Liquidation Incentive

  3. The collateral of the borrower is then seized to pay the liquidator: ($) Collateral Seize = ($) Repaid amount + ($) Liquidation Incentive

Liquidators are rewarded with a liquidation incentive, allowing them to claim the borrower’s collateral at a discount compared to the prevailing market price at the time of liquidation. This bonus is a critical component of the incentive structure, encouraging liquidators to contribute to the stability of the platform by engaging in liquidation activities.

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