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.
When the liquidation of an asset occurs, a percentage of a borrower’s debt is repaid in exchange for collateral.
Once the borrowing limit is exceeded, the borrower's loans can get liquidated by anyone. Liquidations can be done from lending pool's positions page.
The liquidator can repay the debt and claim NFT(s) at a discounted rate relative to their oracle valuation.
If debt is lower that discounted NFT value, remaining change after debt repayment will be split between borrower and protocol.
NFT Liquidation mechanism
During debt repayment process if debt is lower than NFT valuation, change after repayment is converted to dTokens (dUSDC, dETH) and sent to borrower's wallet. Borrower can redeem dTokens for underlying assets after fully repaying debt of second token.
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.
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.