Liquidation is a process in which collateralized assets are sold in order to pay down an outstanding debt position. Liquidations take place at the account level when the total amount of borrowed assets (debt position) reach a high enough percentage of the total amount of collateralized assets (asset position). This percentage is known as the Liquidation Threshold and corresponds to the account Health Factor < 1. Each asset has its own Liquidation Threshold (see Asset Risk) and the overall liquidation threshold is based on the weighted average of collateralized assets.
Liquidations are needed in order to protect the protocol and lenders. Lenders who supply assets and collateralize them are adding assets to a lending pool in order to make loans. If the value of the total borrow exceeds the value of the lending pool then the lenders are at risk of not being able to redeem / withdraw their assets. The liquidation process serves as way to pay down debt when an individual user is unable to do so.
When the user's ERC-20 or ERC-721 Health Factor drop below 1, assets will be sold via liquidation. The Para Space prioritizes liquidating any ERC-20 tokens and ETH before NFTs given their fungibility and greater liquidity. Liquidators can claim ETH and ERC-20 before NFTs.
ParaSpace has a unique liquidation process for NFT to ensure orderly liquidations while maximizing the potential value from liquidation sales. The liquidation contract uses a Dutch Auction with blended price changes to facilitate a progressively dropping "Buy Now" price.
Triggering NFT Liquidations
If a user's ERC-721 Health Factor falls below 1, any user can trigger ERC-721 liquidation auctions on a per-token basis. These auctions serve to protect borrowers, lenders, and the protocol from potential insolvency and brings the user's account to a healthy debt / asset position.
We calculate the ERC-721 Health Factor to assume we will first liquidate ERC-20 tokens and subtract that sum from the debt outstanding:
The protocol utilizes an off-chain keeper to monitor the ERC-721 Health Factor for user accounts and may trigger auctions when a user's Health Factor drops below 1. Any protocol user may likewise trigger liquidations if the Health Factor falls below 1 and initiate a Dutch Auction for ERC-721 tokens in the user's account.
Dutch Auction Buy Now
A Dutch Auction lists a 'Buy Now' price at which any user can purchase the NFT. If the NFT is not purchased, the 'Buy Now' price will decline according to the mechanics described in our Dutch Auction guide. Para Space will charge a liquidation penalty which is then added to the protocol's insurance reserve.
The successful purchase of the NFT terminates an auction. If the user has more than one NFT in auction, any successful sale which puts the user's Health Factor > 1 will remove the user's account from Liquidation status but will not end other auctions in progress.
All liquidations are done in ETH. ETH is used to pay down ETH related debt and any excess returns to the user's account to be used as collateral.
Following a successful auction any surplus ETH will be deposited into the user's account as interest-bearing collateral. This mechanism makes it easier for the user's account to reach the Recovery Health Factor as referenced above and thus end any further ERC-721 auctions in progress.
The user can in turn withdraw these tokens as long as the withdrawal does not leave the user's account with a Health Factor below 1.
You can avoid getting liquidated by staying within your borrow limit. If you are close to reaching your borrow limit you can repay your borrowed amount and/or supply more collateral. By default, repaying has more of an impact on your account Health Factor. Be mindful about price fluctuations of your supplied assets including stablecoins. When the price of your supplied assets decreases you get closer to the liquidation threshold.
Liquidations are open to everyone. You can buy NFTs on liquidation on the ParaSpace DApp. You can liquidate ERC-20 tokens via the smart contract. You can find more details in the developers liquidation section.