Liquidations

What is a Liquidation?

Liquidations on Drops loans ensure that a loan can be repaid under all circumstances via the sale of collateral in a high-risk situation.
Liquidation of an asset is initiated when a borrower exceeds their borrowing limit. The borrowing limit is calculated by taking collateral value and multiplying it by the LTV (Loan to Value) ratio. Example: 1 BAYC at a valuation of 100 ETH with 60% LTV would have a 60 ETH borrowing limit. If the value of your BAYC NFT drops to 90 ETH, the borrowing limit becomes 54 ETH. With 60 ETH in outstanding debt, the borrowing limit becomes exceeded by 11% (60 / 54 *100% - 100)
At this point, the loan becomes available for liquidation.
Borrowing 100% of your borrowing limit carries a very high risk, as anything above the 100% threshold means loans are much more susceptible to liquidation.
When the liquidation of an asset occurs, a percentage of a borrower’s debt is repaid in exchange for collateral.

When will my NFT will be Liquidated?

In order to determine this, we first need to calculate the minimum collateralization ratio (this can be obtained by dividing 100% by the LTV percentage.
For example, assume a BAYC NFT at a 60% LTV gives us a 166.6% minimal collateralization ratio.
How much does the value of the BAYC NFT need to drop for the loan to get liquidated?
Let's say we borrowed 50 ETH when the BAYC's value was 100 ETH. To find out the liquidation price of the loan, we need to multiply the borrowed amount by the minimum collateralization ratio. 50 ETH * 166.6% = 83.3 ETH
As long as the BAYC price doesn't drop below 83.3 ETH and more funds aren't borrowed, the loan will remain solvent.

How is my NFT Liquidated?

Once the borrowing limit is exceeded, the borrower's loans can get liquidated by anyone. The liquidation mechanism depends on how many NFTs have been supplied.
When only 1 NFT is supplied as collateral, the liquidator repays all of the borrower's debt and claims to the NFT. In the near future, an auction mechanism will be implemented for the liquidation of 1 NFT. When 2 or more NFTs are supplied as collateral, the liquidator can repay the debt and claim NFT(s) at a 10% discount relative to their current market value. For example: Assume a user supplies 2 BAYC NFTs valued at 100 ETH each (200 ETH total) - the LTV is 60% and borrowing limit is 120 ETH, where the user borrows 100 ETH. Next, let's say the price of the BAYC NFT drops to 80 ETH - the total collateral value is now 160 ETH, new borrowing limit is 96 ETH, meaning that there's 100 ETH in debt. The loan is now undercollateralized and liquidation gets initiated.
The liquidator can now obtain 1 NFT at a 10% discount - 72 ETH by repaying the borrower's debt. After repayment, the debt is deducted from 100 to 28 ETH and the user is able to keep 1 out of 2 of the NFTs.
The borrower no longer exceeds their borrowing limit and has a 285% collateralization ratio.
If a user had more than 2 NFTs, the amount of liquidated NFTs would depend on how many of them are needed to push the debt below the borrowing limit.

How do I Avoid being Liquidated?

You can avoid being liquidated by keeping the value of your collateral much higher than what is required relative to the value of your loan. This is most easily monitored by looking at your loan’s borrowing limit.
If your debt is exceeding your borrowing limit at a critical level, you can prevent having your collateral from being liquidated by depositing more collateral. You may also activate a second asset as collateral if it has already been deposited into the protocol. In essence, having more collateral provides a greater safety net.