Liquidation is the process of selling collateral to cover the amount of Dai a user has generated from their Vault. Liquidation is the process of selling collateral to cover a user’s generated Dai. A Vault can be Liquidated if the value of its collateral falls below the required minimum level, called the Liquidation Ratio. During the Liquidation process, enough collateral is sold to cover the debt along with a Liquidation Penalty, leaving the remaining collateral available for withdrawal.
Dai is a proxy for the US Dollar, with the additional benefit of being fully backed by real value in the form of various collateral assets. Liquidation helps to ensure that Dai is always backed by an appropriate amount of collateral by closing-out Vaults that are under their minimum required Collateralization Ratio for their given collateral type.
To make sure that the required surplus of collateral exists at all times, a class of users called Keepers are incentivized to maintain a constant watch for Vaults that become under-collateralized. These Keepers are a special category of Maker Protocol users. They are the actors in the system who are incentivized to make sure that the outstanding Dai supply remains fully collateralized and solvent. They help maintain the health of the entire ecosystem by ensuring that undercollateralized Vaults are offered up for Liquidation as quickly as possible. This is particularly important during rapid market downturns as the collateral value could be subject to slippage.
The Liquidation Ratio is the minimum required collateralization level for each Vault type before it is considered undercollateralized and subject to Liquidation. The Maker Protocol’s Oracles provide the system with pricing data that is used to track Vaults for when their Liquidation Ratio is breached. Once breached, they are available for Liquidation.
For example, a Vault with a 150% Liquidation Ratio will require a minimum $1.50 of collateral value for every $1 of Dai generated. If the value of the collateral falls to $1.49 it will be Liquidated to cover the generated Dai in addition to a fee called the Liquidation Penalty.
Each Vault type’s Liquidation Ratio is determined by a combination of the collateral’s risk profile and the Stability Fee. There may be multiple Vault types for each collateral, with varying Liquidation Ratios and Stability Fees.
This is a fee that is paid by Vault owners when their Vaults are Liquidated. The fee is added to the Vault’s total outstanding generated DAI when a Liquidation occurs, which results in more of the collateral being sold on auction.
Proceeds from Liquidation Penalties are put towards the Surplus Auctions, which result in burned MKR.
The penalty is necessary to prevent Auction Grinding Attacks, which essentially break the auction mechanism since an attacker can exploit the Maker Protocol for profit. To read more about this attack read this paper: The Auction Grinding Attack: and a case for a liquidation penalty in Dai.
Liquidation occurs through an Auction mechanism built into the Maker Protocol.
The simplified order of operations looks like this:
A Keeper detects an undercollateralized Vault and triggers a Liquidation.
Part of the collateral is auctioned off to cover the outstanding Dai + Liquidation Penalty
Dai is then burned and the Vault owner receives the leftover collateral
Since Liquidations occur through auctions, there is no way to accurately predict the exact amount of collateral one would receive.
The Liquidation Price for a given Vault is usually shown on front-ends that offer Vaults. Though one can manually calculate their Liquidation Price by using the following simplified formula:
(Generated Dai * Liquidation Ratio) / (Amount of Collateral) = Liquidation Price
Amount of Collateral
(1000 × 1.5 ) ÷ (10) = 150 USD
If we use ETH as an example, it would need to fall to 150 USD before the Vault is considered undercollateralized by the system.
The Collateralization Ratio for a given Vault is usually shown on front-ends that offer Vaults. Though one can manually calculate their Collateralization Ratio by using the following simplified formula:
(Collateral Amount x Collateral Price) ÷ Generated Dai × 100 = Collateralization Ratio
(10 x 300) ÷ 1000 × 100 = 300%
The Vault in this example has a Collateralization Ratio of 300%.
If a user’s Vault is close to the Liquidation Price, they may either add more collateral or pay Dai back into the Vault.
The most efficient way a user can lower their Liquidation Price is to repay DAI. This also has the added benefit of reducing the Stability Fees that accrue for the owner of the Vault. This can be proven by the following example:
(Generated Dai x Liquidation Ratio) ÷ Collateral Amount = Liquidation Price
Current Liquidation Price:
(1000 × 1.5 ) ÷ (10) = 150 USD
Liquidation Price change by adding 400 USD worth of collateral:
(1000 × 1.5 ) ÷ (12) = 125 USD
Liquidation Price change by repaying 400 Dai:
(600 × 1.5 ) ÷ (10) = 90 USD
Remaining aware of a Vault’s condition is the Vault owner’s own responsibility. Ensuring that assets remain safe from Liquidation is entirely in the hands of each Vault owner. Below are some common practices to monitor the health of a Vault:
Vault owners could:
Set up price alerts for the collateral asset(s) being used.
Set up a personal rule that would require them to unwind their Vaults if the collateral price falls below a certain level, this may act as an additional buffer.
Make sure they have adequate access to their Vaults, especially during volatile periods in the markets.
Keep note of their Vault’s number. They can use it as a reference to have an external party payback Dai or add collateral on their behalf if they don’t have immediate access to their Vault.
Make sure they have access to emergency funds or assets that can be readily used to pay back Dai or add more collateral to their positions.
Remember that opening a Vault and generating Dai represents the creation of risk. Vault owners should be very cognizant of this fact and should use Vaults at their own risk.
A flash crash on a single exchange will not affect the system as each Oracle aggregates prices from many sources. The Oracle calculates the median of these prices, which naturally filters outliers like a broken price from an exchange that’s experienced a flash-crash. You can read more about the Maker Protocol’s decentralized Oracles in the Oracle FAQ.