Risk Parameters Used in On-Chain Margin Trading

Detailed Instructions

A position's health factor is continuously calculated based on the current market price of its collateral and debt. This value is derived from the formula: Health Factor = (Collateral Value * Liquidation Threshold) / Total Borrowed Value. When market volatility causes the collateral value to drop or the borrowed value to rise, this factor decreases. The protocol's smart contracts, or an external keeper network, constantly poll this data. The critical moment occurs when the health factor falls below the protocol's liquidation threshold, typically a value of 1.0. For example, a health factor of 0.95 signals the position is eligible for liquidation. This check is permissionless and can be triggered by any network participant seeking the liquidation incentive.

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// Simplified check in a smart contract
function checkLiquidation(address user) public view returns (bool) {
    uint256 healthFactor = calculateHealthFactor(user);
    return healthFactor < LIQUIDATION_THRESHOLD; // e.g., 1.0 * 10**18
}

Tip: Positions often have a liquidation buffer (e.g., health factor between 1.0 and 1.1) where they are at risk but not yet liquidatable. Monitoring tools can alert you in this zone.

Detailed Instructions

Any external address can act as a liquidator by submitting a transaction to the protocol's main liquidation function, such as liquidate(address user, uint256 debtToCover, address collateralAsset). The liquidator must specify the undercollateralized user's address and the amount of the borrowed asset they wish to repay. Crucially, the liquidator must already hold, or have approved the protocol to spend, the required amount of the debt asset (e.g., USDC, DAI). This capital is used to pay off a portion of the user's debt. The transaction includes a gas fee, and liquidators often run bots to compete for profitable opportunities. The function call will revert if the position's health factor is now above the threshold, a condition known as a failed liquidation.

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// Example function call via ethers.js
const tx = await lendingContract.liquidate(
  underwaterUserAddress,
  ethers.utils.parseUnits("500", 6), // Repay 500 USDC
  wethAddress // Receive WETH as collateral
);

Tip: Liquidators calculate profitability by comparing the liquidation bonus (discount on collateral) against gas costs and price slippage. They often use flash loans to source the debt asset capital.

Detailed Instructions

Upon a valid liquidation call, the protocol's smart contract performs several atomic state changes. First, it transfers the specified amount of the debt asset from the liquidator's balance to the protocol's treasury, reducing the target user's total debt. In return, the contract calculates the amount of collateral asset to seize and transfer to the liquidator. This amount is the value of the repaid debt, plus a liquidation bonus (or penalty), divided by the current oracle price of the collateral. For instance, with a 5% bonus, repaying $1000 of debt might grant the liquidator $1050 worth of collateral. The contract updates the user's debt and collateral balances internally and transfers the seized tokens. This step is non-custodial and requires no intermediary.

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// Core logic snippet for collateral calculation
uint256 collateralPrice = oracle.getPrice(collateralAsset);
uint256 bonusAmount = (debtRepaid * LIQUIDATION_BONUS) / 10000; // Bonus in basis points
uint256 collateralToSeize = (debtRepaid + bonusAmount) / collateralPrice;

// State updates
userDebt[user] -= debtRepaid;
userCollateral[user] -= collateralToSeize;
safeTransfer(collateralAsset, liquidator, collateralToSeize);

Tip: The liquidation bonus is a key risk parameter. A higher bonus incentivizes faster liquidations but increases the loss for the position holder.

Detailed Instructions

After the liquidation transaction is mined, the protocol recalculates the position's health factor. The primary goal is to bring this factor back above the liquidation threshold (e.g., 1.0). However, a partial liquidation may not fully restore health to a safe level (e.g., >1.5). The remaining debt and collateral are adjusted accordingly. If the health factor is still below the threshold, the position remains eligible for further liquidation by other liquidators. The user retains ownership of any remaining collateral and is still responsible for the remaining debt plus accrued interest. The protocol's event logs will emit the new health factor, allowing users and monitoring services to track the updated state. This step ensures the system's solvency is maintained incrementally.

• Check new health factor: Query the user's updated health via a view function.
• Assess remaining risk: Determine if the position is still at immediate risk of another liquidation.
• User options: The position holder can now add more collateral or repay debt manually to improve their health factor.

Tip: In volatile markets, a position can undergo multiple, rapid liquidation waves from different liquidators until its health is restored or it is fully liquidated.

Detailed Instructions

The liquidation mechanism includes an incentive structure to ensure system stability. The liquidation bonus awarded to the liquidator is the primary incentive. Additionally, the protocol may take a liquidation fee from the seized collateral, which is often directed to a protocol treasury or a safety module. Some protocols also use a portion of the fee to buy back and burn their native governance token. The exact breakdown is defined in the protocol's risk parameters and smart contract logic. For example, a liquidation might involve a total penalty of 10% on the repaid debt, with 8% going to the liquidator and 2% to the protocol treasury. This step finalizes the economic redistribution, ensuring keepers are compensated and the protocol captures value for managing risk.

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// Example incentive distribution
uint256 totalLiquidationPenalty = (debtRepaid * TOTAL_PENALTY_BPS) / 10000; // 10%
uint256 liquidatorBonus = (debtRepaid * LIQUIDATOR_BONUS_BPS) / 10000; // 8%
uint256 protocolFee = totalLiquidationPenalty - liquidatorBonus; // 2%

// Distribute
collateralToSeize = (debtRepaid + totalLiquidationPenalty) / price;
transferCollateral(liquidator, liquidatorBonusPortion);
transferCollateral(protocolTreasury, protocolFeePortion);

Tip: The size of the liquidation bonus is a critical parameter balancing incentive for liquidators against excessive penalty for users. Protocols may adjust it via governance.