📸Liquidation

Liquidation is a process that occurs when HF of a borrower falls below 1 because the borrower's collateral does not adequately cover the value of the deposit/borrow. This can happen when the value of the collateral decreases or the value of the deposit/borrow increases with respect to each other. In the liquidation phase, up to 50% of the borrowed asset is repaid and its value plus a liquidation penalty is taken from the available collateral. Therefore, after the liquidation, that amount liquidated from the debt will be repaid.

The liquidation penalty (or bonus for liquidators) depends on the asset used as collateral. You can find every asset's liquidation penalty in Risk Parameters.

How lTokens and vdTokens Work in Liquidation

1. lTokens (Liquidity tokens): When a user deposits an asset like WETH into the Palmy protocol, they receive an equivalent amount of lTokens (e.g., lWETH for WETH). The lToken represents the user’s deposit and any accrued interest. The balance of these tokens increases over time as interest is accrued on the deposited asset.

2. vdTokens (Variable Debt Tokens): When a user borrows an asset, they receive vdTokens representing the amount they owe. The balance of these tokens will increase over time due to the variable interest rate applied to the borrowed amount.

Liquidation Mechanism in terms of lTokens and vdTokens:

When the health factor of a user's position drops below 1 due to price fluctuations of their collateral or borrowed assets, their position becomes vulnerable to liquidation. Liquidators repay a portion or all of the borrower's outstanding debt (represented by the vdTokens). In return, they receive a corresponding portion of the borrower's collateral (represented by the lTokens) that is equal to the repaid debt value, plus an added liquidation bonus taken from the borrower's collateral.

Examples:

Example 1: Alice deposits 50 WETH into the Palmy protocol. She receives 50 lWETH in return. Later, she borrows 2000 DAI and receives a corresponding amount of vdDAI.

If the value of WETH drops, causing Alice’s Health Factor to fall below 1, her position becomes eligible for liquidation.

A liquidator decides to repay 50% of Alice’s borrowed DAI (1000 DAI). In return, the liquidator claims a corresponding portion of Alice's WETH collateral, plus a 5% liquidation bonus.

Alice's lWETH balance decreases by the equivalent value of the repaid DAI, plus the 5% liquidation penalty. Meanwhile, her vdDAI balance reduces by the 1000 DAI repaid.

Example 2: Bob deposits 1000 OAS into Palmy and gets 1000 lOAS. He decides to borrow 5 WETH, receiving the corresponding amount of vdWETH.

If WETH's price increases significantly, causing Bob's Health Factor to fall below 1, his position becomes open to liquidation.

A liquidator chooses to repay 2 of Bob's borrowed WETH. For doing so, the liquidator receives a portion of Bob's OAS collateral, with an added 5% liquidation bonus.

Bob's lOAS balance reduces by the equivalent value of the repaid WETH and the liquidation penalty. Meanwhile, his vdWETH balance reduces by the 2 WETH.

How to prevent from liquidation

Users should add more collateral or repay some of their debt before their Health Factor (HF) drops below 1 to prevent liquidations