Each exchange has a maximum leverage and minimum collateral. If either of these are violated, the trade will become liquidatable. This means that anyone can send a transaction to forcefully close the trade, and they will receive part of the remaining collateral in return.
For example, if an exchange's max leverage was 30x and due to an adverse price move a trade became 30.1x leverage, then it could be liquidated by anyone. Trades can be liquidated when they do not have the minimum amount of collateral (for example 100 USDC) left in them because the liquidator needs to be able to earn enough of a fee to pay for the gas of liquidating the trade. If there was no minimum collateral amount, someone could attack the protocol by opening up a significant number of tiny trades that would not be economical to liquidate.
Liquidations are forced closes of trades by anyone who sends in the transaction with the target trader’s address (some people will have liquidation bots performing this automatically). A trade can only be liquidated if it violates the margin requirements (ie, it exceeds the max leverage or violates min collateral). This can happen for 3 reasons:
- 1.The price of the underlying asset moves against the trader, causing their position to be above the maximum leverage or to violate the minimum collateral requirements.
- 1.Long: A trader opens a 10x trade for 1 unit of asset when the asset is at $100. The trader will need to be liquidated before the price falls below $90.
- 2.Short: A trader opens a 10x trade for 1 unit of asset when the asset is at $100. The trader will need to be liquidated before the price goes above $110.
- 3.Minimum Collateral Violation: Min. Collateral is set to 10 USDC. A trader opens a 10x trade for 0.2 unit of asset when the asset is at $100. If the price of the asset drops so that the trader only has <10 USDC of collateral left (even if the price is above the liquidation price) they will be liquidatable.
- 2.The funding rate causes losses for the trader by moving funds from the side (long or short) that is too popular (more open interest) to the other side. This creates an incentive to open the less in-demand trade type to earn the funding rate.
- 3.Time Fee causes losses for the trader.
- 1.There is an optional time fee that can be turned on that is charged to all open trades and is earned 100% by the liquidity providers. This is designed in case there is not enough trade volume, but lots of longer-term open interest. The LPs can still make money from open interest rather than just trade open and close fees.
Liquidations have three routes for closing:
- 1.Close the trade via Uniswap as if the trader had initiated a normal close. This assumes that there is enough FS Liquidity to facilitate the trade.
- 2.Auto DeLeverage (ADL) at the trades bankruptcy price. This means that the solvent trades getting closed unwillingly are getting closed at a premium (liquidation price - bankruptcy price) to compensate them (see ADL section below).
- 3.Bankrupt trades mean that the trader has run out of collateral and cannot fully cover their debt. The trade should be closed, and no swapping should occur.