6.5.2 Rob's Liquidation

Socialized clawback practical example

Example: Rob's Liquidation in Leveraged Yield Farming

Meet Rob, an adventurous DeFi enthusiast looking to maximize his yields in the world of leveraged yield farming. Rob decides to participate in a leveraged yield farming pool that allows him to borrow funds and amplify his potential returns. He begins by providing collateral and borrowing assets to boost his farming position.

Initial Position:

• Collateral (ETH): 5 ETH

• Borrowed Asset (Token X): 100 Token X

• Collateralization Ratio: 200% (Rob's borrowed assets are twice the value of his collateral)

Market Volatility and Liquidation Risk:

As with any leveraged position, Rob's leveraged yield farming strategy comes with risks, particularly related to price volatility. Unfortunately for Rob, Token X experiences a sudden and sharp price drop due to unexpected market events. The value of Token X significantly declines, impacting the overall value of Rob's position.

Liquidation Event: As a result of the price drop, the value of Rob's borrowed assets (100 Token X) decreases, and his collateralization ratio falls below the required threshold. In this example, the platform requires a collateralization ratio of 150% to maintain the position. However, due to the price decline, Rob's collateralization ratio drops to 140%.

Liquidation Trigger: Once Rob's collateralization ratio falls below the required threshold, the liquidation mechanism is triggered. The platform's smart contract automatically initiates the liquidation process to protect the platform and other users from potential losses.

Socialized Clawback: In this case, there are insufficient funds in the leveraged pool to cover the negative balance resulting from Rob's liquidation. As a risk management measure, the platform employs a socialized clawback mechanism to distribute the losses across all users in the pool.

Proportional Loss Allocation: The socialized clawback calculates the proportion of losses that each user in the pool needs to bear. Rob's portion is determined based on the size of his position relative to the total value of the pool at the time of liquidation.

Impact on Rob: As a result of the socialized clawback, Rob experiences partial losses. The platform reduces his collateral and returns a portion of it to compensate for the negative balance in the pool. While the losses are shared among all participants, Rob's position and overall funds decrease due to the liquidation event.

Key Takeaways: Rob's liquidation illustrates the importance of risk management in leveraged yield farming and the impact of market volatility on leveraged positions. Participating in leveraged strategies requires careful consideration of the potential risks, collateralization ratios, and the potential for socialized clawbacks. Traders like Rob must be aware of the dynamic nature of DeFi markets and make informed decisions to manage risks effectively in this high-reward, high-risk landscape.