Liquidations
Liquidations are a critical mechanism that ensures the stability, solvency, and safety of the lending markets. When a borrower's position becomes undercollateralized — meaning the Loan-to-Value (LTV) ratio exceeds the market's Liquidation Loan-to-Value (LLTV) threshold — the position becomes eligible for liquidation. This process safeguards lenders by allowing the protocol to recover the borrowed funds while preventing systemic risk.
Liquidation Bonus
In Dahlia, a liquidation bonus is applied as a fee paid by the borrower to the liquidator. This bonus is deducted from the borrower's collateral upon liquidation and serves as an incentive for liquidators to repay the borrower's debt.
Key Characteristics:
Set by Market Deployer: The market deployer determines the liquidation bonus at the time of market creation.
Adjustable by Market Admin: Post-deployment, the market admin can adjust the bonus to align with evolving market dynamics.
Upper Bound: The liquidation bonus cannot exceed ¾ of the difference between the LLTV and 100%.
This mechanism ensures that liquidators are fairly incentivized while maintaining a buffer between the LLTV + Liquidation Bonus and 100% LLTV. This buffer provides critical time and room for liquidators to process liquidations efficiently, reducing the likelihood of bad debt.
Liquidation Process
Dahlia employs full liquidations instead of partial liquidations. When a borrower's position crosses the LLTV threshold, the entire debt is repaid, and the corresponding collateral (including the liquidation bonus) is seized.
Why Full Liquidation?
Minimizes Risk: By liquidating the full position, Dahlia reduces the chances of prolonged undercollateralization.
Simplifies Execution: Full liquidations streamline the process for liquidators and the protocol, ensuring positions are cleared promptly.
Reduces Bad Debt: Partial liquidations can leave residual risk; full liquidation eliminates this exposure.
Steps in the Liquidation Process:
Determine Eligibility: The borrower's position is flagged for liquidation once the LLTV threshold is breached.
Seize Collateral: The protocol calculates the amount of collateral to be seized, factoring in the liquidation bonus for the liquidator's reward.
Full Repayment: The liquidator repays the borrower's outstanding debt, and the corresponding collateral — including the liquidation bonus — is transferred to the liquidator.
Handle Bad Debt: If the seized collateral is insufficient to cover the borrower's debt, the remaining shortfall is marked as bad debt.
Reserve Fees and Bad Debt
To mitigate the risks associated with bad debt, Dahlia incorporates reserve fees into its risk management framework.
How Reserve Fees Work:
Governance-Enabled: Reserve fees can be enabled or adjusted by governance as needed.
Collected from Borrowers: A portion of borrower payments is directed to the reserve pool.
Forms a Safety Buffer: The reserve pool acts as insurance, helping cover unexpected losses from liquidations where collateral is insufficient.
Handling Bad Debt:
In the event of bad debt:
The protocol attempts to use funds from the reserve pool to cover the shortfall.
This reduces the impact on lenders and maintains the financial health of the market.
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