POW #1.1- Maker - Liquidation Process
In our previous article , we understood how Maker operates. One key element on Maker is the liquidation process & various parties involved. The incentives of each external actors must be aligned so as to ensure that the Protocol operates safely & efficiently.
Types of Liquidation
There are 3 categories of Liquidation in Maker.
Collateral Auction :- All the collateral assets added to vault must meet the “minimum liquidation ratio”. If any vault is under-collateralised due to price crashes, the collateral is auctioned off to cover to outstanding DAI & liquidation penalty.
Surplus Auction :- when stability fees earned in Dai reaches a certain limit, the additional DAI is auctioned off for MKR. Thus received MKR coins are burned to reduce supply.
Debt Auction :- Say if price crashes & the collateral being auctioned off could not cover the cost of outstanding DAI, then outstanding debt will be left in liquidation vault. At first, the debt can be attempted to cover using stability fee earned by the Maker platform. If system does not have enough DAI to cover the debt, then “Debt auction” is triggered. The bidder pays Dai against the Debt & receive newly minted MKR coins- thus increasing the supply of the coin.
The mechanics of Surplus & Debt auction have direct bearing on supply on MKR coin. A healthy Maker platform should reduce MKR supply in circulation & hence boosting its price. Alternately, if too much unpaid debt accrues in the system , new MKR coins are issued - increasing overall supply & reducing price.
Why Liquidation process?
Any collaterals locked in the vaults with outstanding DAIs generated against qualify as obligations to be repaid. When the asset was deposited & Dai was generated, user technically took loan from the Protocol with agreed upon stability fee( interest ratio) & liquidation ratio. In case the price of the collateral asset crashes ( say Ether) & liquidation ratio goes below the current active ratio value for the vault, the liquidation process is triggered to ensure outstanding DAI is recovered.
How is Liquidation initiated?
A special category of Maker users called - “Keepers” warrant introduction here. Keepers are incentivised to search for collateralised vaults that become eligible for liquidation. They help maintain the protocol & Dai value stable , specially during market downturns.
How is liquidation process completed?
Liquidation process is managed through “auction mechanism” built into the Maker protocol.
At first the keeper detects an under collateralised vault & triggers the liquidation process. You as Maker user though can proactively avoid liquidation trigger by paying back outstanding DAI or adding additional collateral to ensure liquidation ratio stays above the minimum threshold.
However, if the liquidation process is triggered, you are also liable to pay-up the eligible “liquidation penalty” fee. Hence the collateral will be auctioned to cover for :- Dai generated + Stability fee+ Liquidation penalty.
With the auction process, once the outstanding Dai+liquidation fee is covered, the auction changes course.
At this stage now, auction bidders now offer lesser collateral against the Dai they agreed to pay-up in previous stage.
Upon closure, the bidders receive the collateral they bid for.
The dai they paid up for bid is burned.
Any leftover collateral is returned to the vault owner.
More on Keepers
Keepers (either Humans or Bots) can monitor the prices on Ethereum blockchain & identify “Vault” eligible for liquidation.
The auction mechanism is designed to be quick. Bidders willing to bid for the collateral send their DAI to a specific address. if a new higher bid is submitted , the loser bidder is refunded back his DAI. Please note the only way to cancel a bid is when a new bidder bids higher than your bid.
Each auction has few parameters defined by MKR governance such as minimum bid increase , bid duration & auction duration.