Liquidations

What are Liquidations?

Liquidations play a vital role in maintaining the stability of the RateX protocol. When traders leverage their positions by depositing margin, they gain increased exposure to the underlying asset's yield. However, as market movements fluctuate, positions can experience negative unrealized PnL. This negative PnL can erode the deposited margin, potentially creating a risk for the protocol.

To ensure the system's health and protect all users, RateX employs a Collateral Ratio (CR) as a key indicator for leveraged yield trading positions. The CR reflects the health of a position and is calculated as follows:

$$CR = \frac{AssetValue + DepositedMargin}{LiabilityValue}$$

Maintaining a sufficient Collateral Ratio is crucial to avoid liquidation. If the CR of a position falls below a designated threshold, known as the Maintenance Collateral Ratio (MCR), a liquidation event is triggered. This process serves to safeguard the protocol and its users from further losses.

Aftermath of Liquidation: Restoring Protocol Health

When a liquidation event is triggered due to a Collateral Ratio (CR) falling below the Maintenance Collateral Ratio (MCR), the RateX protocol's liquidation engine takes control of the position to minimize losses. This process follows a specific order to ensure the system's stability:

Step 1: Insurance Fund Intervention

When a trader’s collateralization ratio (CR) falls below the maintenance CR, the insurance fund will begin to take over the trader’s position, including YT, ST, and margin. If the net value of the insurance fund falls below zero, it will trigger ADL (Auto-Deleveraging)

Step 3: Auto-Deleveraging

During ADL, we close the counterparties’ positions to the insurance fund at the bankruptcy price, which is the current market price at that time. If the insurance fund holds a long position in YT, traders holding short positions may face the possibility of having their positions reduced at market price.

So, how do we determine which short positions will be reduced? We have an ADL sequence algorithm that ranks traders based on their profit and leverage levels. The counterparties to the insurance fund’s position are then reduced according to this ranking.

Step 4: Socialized Position Transfer for LP

If the gross counterparty's position still can’t absorb the ADL amount, the LPs will need to cover the remaining amount.