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Borrowers and liquidation

How borrower leverage, position size, liquidation rules, and recovery determine bad debt.

From a price fall to bad debt

  1. Collateral value falls The collateral behind a loan loses value against the debt it secures.
    If the fall continues, the collateral value reaches the liquidation threshold.
  2. Liquidation threshold The level at which the lending protocol allows the position to be liquidated.
    Once the threshold is crossed, any liquidator may settle the position.
  3. Liquidation A liquidator repays the debt and receives the collateral plus the incentive.
    The liquidator now holds collateral and needs the loan asset back.
  4. Recovery The seized collateral is sold or redeemed for the loan asset through a supported route, after fees and delay.
    If the recovered value is less than the debt, the difference is unpaid.
  5. Bad debt Debt still unpaid after recovery is the market's loss. The vault bears its share.
A collateral price fall carries a loan to the liquidation threshold. A liquidator repays the debt and receives the collateral plus the incentive, converts it through a supported recovery route, and any debt still unpaid becomes bad debt for the market.

Borrower groups

A lending market contains loans of different sizes and safety margins. The model groups borrowers by:

  • debt size;
  • collateral value;
  • distance from the liquidation threshold; and
  • the share of market debt represented by the group.

These groups preserve the shape of the borrower book. A market with many well-collateralized loans behaves differently from one where a few large positions sit near liquidation.

When liquidation begins

A loan becomes eligible for liquidation when its collateral value falls below the market's threshold. The protocol's price feed determines when this condition is visible. The model then applies the liquidation incentive, execution quality, and the recovery value of the seized collateral.

Liquidation size comes from the borrower group involved in the event, which keeps the sale close to the size of the position being settled.

One settlement per loan

Each loan settles once in a simulation path. Later events leave settled debt unchanged. If a price feed delays liquidation, settlement occurs when the unsafe position becomes visible or at the end of the assessment period if it remains unresolved.

From liquidation to bad debt

The calculation follows four steps:

  1. Identify the borrower group that reaches liquidation.
  2. Calculate the collateral received after the liquidation incentive.
  3. Apply the available recovery route at that collateral amount.
  4. Record any unpaid debt as market loss.

The vault receives its share of that market loss according to its supplied position.

Continue with Price feeds and oracle risk.