What is Soft Liquidation?

Understanding the mechanics of liquidations is fundamental to safely participating in decentralized finance (DeFi). For borrowers, liquidations represent a boundary condition and risk that must be intelligently managed. For lenders, they serve as a safety mechanism that ensures debt repayment and interest rate stability.

What Is Liquidation in DeFi?

Liquidations serve as a fundamental safety mechanism in DeFi lending, allowing protocols to close borrower positions before they accumulate bad debt. In overcollateralized lending protocols like Granite, all debt is secured by collateral provided by the borrower. Bad debt arises if the value of this collateral falls below the outstanding loan amount, leading to a scenario where even if all of a borrower’s collateral were sold it still would not fully repay the debt.

To prevent this undesirable outcome, protocols liquidate a portion (up to 100%) of a borrower’s position before it reaches this critical threshold.

The Liquidation Process

When a liquidation is executed, the following sequence occurs:

1. Identification: A liquidator identifies a borrower position that has passed the liquidation threshold
2. Repayment: The liquidator submits a transaction to repay some or all of the borrower’s debt
3. Validation: The protocol validates that the position is liquidatable
4. Reward: The liquidator receives an equivalent amount of the borrower’s collateral, along with a liquidation reward, in exchange for closing the position

From the liquidator’s perspective, executing a liquidation is akin to purchasing collateral at a discount with the discount being equal to the liquidation reward.

Factors Influencing Liquidations

To fully grasp liquidations, it is important to understand several core concepts.

LTV (Loan-to-Value) Ratio

The ratio of the loan amount to the value of the collateral. A higher LTV indicates increased risk because the borrower has borrowed more relative to the collateral provided.

Max LTV

A max LTV refers to the  maximum LTV to which a borrower is able to increase their debt amount.

Liquidation LTV

The liquidation LTV is the LTV threshold at which a borrower’s position becomes eligible for liquidation.

Liquidation Point

A liquidation point is the specific value of the collateral at which the position reaches the liquidation LTV.

Liquidation Reward

A liquidation reward is an incentive for liquidators to close positions, typically a percentage of the collateral.

A Calculated Example of Liquidation Factors

So how do these liquidation factors come together? Let’s take the following example:

• Max LTV: 65%
• Liquidation LTV: 80%
• Collateral Value: $100,000

In this scenario:

• Maximum Borrowable Amount: $65,000 (calculated as $100,000 * 0.65)‍
• Liquidation Point (with $65,000 borrowed): $81,250 (calculated as $65,000 / 0.8). If the collateral value falls to this point, the position becomes eligible for liquidation.

What Happens as Prices of Collateral Change?

Price fluctuations in crypto markets directly impacts the health of a borrower’s position. If you want to understand how changes in collateral value impact key variables, take this initial position as an example:

• Collateral Value: $100,000 of BTC
• Borrowed: $65,000
• Initial LTV: 65% (max LTV)
• Liquidation LTV: 80%
• Liquidation Point: $81,250 (calculated as $65,000/0.8)

If the price of BTC increases:

• Collateral Value increases to: $125,000
• LTV decreases to: 52% ($65,000/$125,000)
• Borrowing Power increases: The borrower can now borrow an additional $16,250 (0.65 * $125,000 - $65,000)
• Result: The position moves further away from the Liquidation Point (it’s safer)

If the price of BTC decreases:

• Collateral Value decreases to: $90,000
• LTV increases to: 72% ($65,000/$90,000)
• Borrowing Power decreases: The borrower’s LTV is greater than the max LTV, so they can’t borrow any more‍
• Result: The position moves closer to the Liquidation Point (it’s riskier)

Classic Liquidation Practices in DeFi

Most DeFi lending protocols allow liquidators to close a significant portion of a borrower’s position in a liquidation, most often between 50% to 100% of the position. This is catastrophic for borrowers as they can lose a significant portion of their position during temporary price declines, even if prices recover minutes later.

Let’s look at two examples to understand the impact of 50-100% liquidations.

50% Liquidation

In this scenario, we have:

• Initial Position: $65,000 borrowed with $81,000 collateral (slightly below the Liquidation Point)
• Max Liquidation: 50% ($32,500)
• Liquidation Reward: 10%

The liquidation outcome is:

• Debt Repaid by Liquidator: $32,500 (50% of debt)
• Collateral Received by Liquidator: $32,500 (repaid debt) + $3,250 (10% liquidation reward) = $35,750 of collateral
• Collateral Lost by Borrower: 45% of their collateral ($35,750 / $81,000)

100% Liquidation

In this scenario, we have:

• Initial Position (same): $65,000 borrowed with $81,000 collateral (slightly below the Liquidation Point)
• Max Liquidation: 100% ($65,000)
• Liquidation Reward: 10%

The liquidation outcome is:

• Debt Repaid by Liquidator: $65,000 (100% of debt)
• Collateral Received by Liquidator: $65,000 (repaid debt) + $6,500 (10% liquidation reward) = $71,500 of collateral
• Collateral Lost by Borrower: 88% of their collateral ($71,500 / $81,000)

These examples illustrate how classic DeFi liquidation mechanisms can have devastating impacts for borrowers, even during short-term market fluctuations. There is a better way.

Soft Liquidation Explained

Granite introduces a more borrower-friendly model known as “soft liquidations.” Instead of liquidating 50-100% of a borrower’s collateral, Granite only liquidates the minimum amount needed to return the position to a healthy state where the position’s LTV is lower than the Liquidation LTV. This preserves significantly more of the borrower’s collateral.

Granite’s Soft Liquidation example:

• Initial Position (same): $65,000 borrowed with $81,000 collateral (slightly below the Liquidation Point)
• Max Liquidation: back to Liquidation LTV (80%)
• Liquidation Reward: 10% In this liquidation:

Liquidation outcome:

• Debt Repaid by Liquidator: $1,669 (minimum amount needed to return LTV to Liquidation LTV)
• Collateral Received by Liquidator: $1,669 (repaid debt) + $167 (10% liquidation reward) = $1,836 of collateral
• Collateral Lost by Borrower: 2% of their collateral ($1,836 / $81,000)

This approach can significantly reduce the impact of liquidations on borrowers, allowing them to better weather downturns without suffering a catastrophic loss of collateral.

Granite enables soft liquidations through an efficient batch liquidation system that allows for liquidators to process multiple positions in a single transaction. This approach maintains protocol stability while minimizing collateral loss.

Conclusion

With Bitcoin, an asset that has enormous potential value and long-term importance, it’s worthwhile to take a low-risk approach and carefully select the DeFi protocols based on the risks they create and mitigate. Understanding a protocol’s liquidation mechanics can make the difference between weathering temporary downturns or suffering a catastrophic collateral loss.

Granite’s approach to liquidations exemplifies how protocols can offer a safer experience for borrowers while maintaining the necessary safeguards to protect LPs and ensure long-term protocol sustainability.

With Granite, you can confidently navigate the world of Bitcoin liquidity without compromising on trust or safety. And remember: while Granite’s soft liquidation mechanism provides additional protection, it’s still crucial to maintain healthy collateral ratios and actively manage your positions in drawdowns.

Never sell.