Understanding the Risks
Regardless of the market, if you have been involved in trading for any amount of time the concept of “liquidation” is certainly a familiar one. However the context that many have heard this term used probably refers to “getting rekt” with leveraged trading on platforms like Bitmex. In those cases, liquidation means that an entire position was lost, resulting in 100% losses that cannot be recovered. Liquidation in DeFi is a completely different beast, and the maths behind it can be confusing. In this article we’re going to explain how liquidation with UMA works, and walk through a couple of examples.
Understanding Liquidation on UMA Protocol
UMA protocol specialized in priceless synthetic assets. These are collateralized assets with expiration dates, and using them does not require calling a price oracle (that is — until expiration). As is the nature of collateralized assets, a user must lock in an amount of funds greater than the value of the asset they are minting and maintain a certain ratio of collateralized funds to their minted position. This method allows the user to retain exposure to their collateral assets, while simultaneously leveraging these assets as a loan. When minting new synthetics, users can choose any collateralization ratio that they wish — but it must be above the GCR (Global Collateralization Ratio). For example, at time of writing the GCR for uUSDwETH-DEC20 is 2.55993781. This means that the token sponsor must post at least 2.55993781x the amount of collateral relative to the position they are taking.
While the GCR limits the amount of new synthetics that can be issued, this ratio does not have to be maintained in order to avoid liquidation. The collateral requirement for all synthetic assets is 1.25 — meaning that if the collateralization ratio falls below 1.25, a liquidator may terminate your position. Note: With UMA, liquidations are not automatic. The protocol itself does not liquidate any position. Rather, a user (or bot — more on that later) must manually liquidate an under-collateralized position and post a “liquidator bond” to process the liquidation.
Since synthetic assets do not rely on an oracle until expiration, it stands to reason that no oracle is used in the liquidation process either! You might find yourself wondering “how in the world does this work??” When a liquidator attempts to liquidate an under-collateralized position and posts the bond, the funds are not immediately transferred. Instead, at that moment the undercollateralized position enters a “Liquidation Liveness Period” where the liquidation itself may be disputed. In other words, a window of time is opened for people to check the math and see if the position is actually under collateralized. Right now, the liquidation liveness period is two hours — ample time for someone to check the math and dispute an incorrect liquidation.
This is the failsafe for the protocol. Technically, any position may be liquidated — but if it is done so incorrectly, the attempted liquidator will lose their liquidation bond, which is currently 1 WETH. That is a hefty price to pay for mistakes, so check your math before attempting to liquidate! Likewise, there is a bond for disputing a liquidation. In this case, the dispute bond is 10% of the disputed position + 1 WETH. Anyone may dispute a liquidation — not necessarily the owner of the position in question.
In the case of a disputed liquidation, UMA’s oracle (the DVM) will be called and the dispute will be put to a vote. If it is found that the position was incorrectly liquidated, the disputer will receive back their bond plus a reward, and the liquidator will have to pay the dispute reward and the improper liquidation reward, which goes to the token sponsor.
This table from UMA’s documentation is helpful for understanding/summarizing these payouts:
How Much Can I Lose If I’m Liquidated?
As we mentioned in the opening paragraph, liquidation here is not the same as it is with margin trading. Instead of losses of 100% or more, losses from under collateralized positions are not nearly as devastating. Let’s look at an example:
A user named Bob has a position that has just become under collateralized. His CR is now 1.24 and he is at risk for liquidation. Bob had minted 1000 uUSD and now the backing collateral is only 1.24x his minted position, or $1,240. Before he can add more collateral, his position is liquidated and he chooses not to dispute. When the liquidation liveness window ends, his position is closed and he loses his $1,240. But Bob still has his 1000 uUSD, worth $1000 at expiration. In this case, Bob has only lost $240, representing about 19.4% of his collateral before liquidation. Thus, the liquidation event in itself is not a total loss.
Now let’s say that Bob’s position was liquidated, but his CR was 1.5 when the liquidator made their claim. A user notices the incorrect liquidation and disputes the claim before the liveness window closes. The DVM vote confirms that the liquidation is incorrect, and Bob’s funds are returned to him, with a reward for his trouble. In this case, the liquidator is penalized and both Bob and the disputer get a nice bonus.
How To Participate in Liquidations
Anyone is able to liquidate under-collateralized positions using the interface provided by UMA. Follow the below steps to participate!
Step 1: Navigate to tools.umaproject.org
Step 2: Connect Your MetaMask
Step 3: Select an EMP
Step 4: Click the “All Positions” Tab
Step 5: Find a position ready for liquidation
Note: No positions are currently below the 1.25 CR threshold at this time.
Step 6: Click the “Liquidate” Tab
Step 7: Enter the number of tokens to liquidate and set deadline
Step 8: Submit Liquidation and approve transactions!
Congratulations, you’re now an expert on liquidating under-collateralized positions on UMA protocol!
Building A Liquidation Bot
Why watch positions all the time when you can create a bot to do it for you? UMA has a great collection of resources that will help you get a liquidation and dispute bot up and running! Click here to check out their docs.
If you have experience setting up bots, please consider running one on UMA! These bots are crucial to the success of the UMA protocol and are integral to priceless synthetic contracts’ smooth operation. UMA has continuously encouraged the deployment of such bots, and has incentivized them on multiple occasions by creating liquidation opportunities for the bots to catch. You can read more about UMA’s liquidation opportunity program by clicking here.
This article was written for educational purposes and should not be taken as investment advice. Always do your own research and consult your financial advisor before making an investment decision.