How liquidations on Hedge work
As part of our launch of Hedge, a protocol for 0% interest lending on Solana, we want to explain one of the most important mechanisms for users to be aware of: liquidations.
You may have only heard of liquidations as something scary, you may be familiar with them on other platforms, or you may know nothing about them at all, but whatever the case, this post will teach you how they work within Hedge.
We’ll cover what liquidations are, how to protect yourself from them, and why they’re important to the health of Hedge.
What are liquidations?
Hedge allows users to store their SOL in a vault as collateral, in order to take out loans in our stablecoin USH (see our intro post to learn more about Hedge). However, if a vault’s collateral drops in value or the owner takes out a high loan relative to their collateral, it’s possible that the user won’t be able to pay back their loan.
Liquidations protect Hedge by closing these risky, undercollateralized loans. When a vault is liquidated, that means the protocol has closed the vault’s loan and distributed its collateral to the Stability Pool (more on the Stability Pool below).
Don’t worry, though, liquidations can’t just happen whenever. Vaults can only be liquidated if they drop below a minimum collateral rate threshold. For the vault types currently available on Hedge, this threshold is 110% if the system isn’t in Recovery Mode. You can check the minimum collateral ratio in the name of the vault type — most of the vaults currently on Hedge are SOL-110%.
If a vault’s collateral rate does drop below the minimum threshold, it can then be liquidated.
Assuming 1 SOL = $100, a SOL-110% type vault with a 10,000 USH loan against 109 SOL only has a 109% collateral ratio. The collateral ratio is below the 110% minimum threshold for this type of vault, so it can be liquidated.
To make liquidations easier, Hedge maintains an in-app list of vaults that are eligible to be liquidated. If you initiate a liquidation, you earn a reward for helping keep Hedge healthy.
How do liquidations work?
When a Hedge loan is taken out, the USH for that loan is minted and given to the borrower. When a loan is repaid, the USH used to repay it is then burned. This keeps the overall supply of USH balanced with the total value of outstanding loans.
In order to maintain that balance, a vault’s debt can’t just disappear when it is liquidated. The loan has to be paid off by someone so the same amount of USH can be burned.
So, to cover the debt of liquidated vaults, Hedge maintains a Stability Pool. Users can stake USH in the pool to receive the SOL from liquidated vaults. Stability Pool stakers also receive our governance token HDG as a reward.
In order to liquidate a vault, Hedge repays the debt by taking USH out of the Stability Pool and burning it. Hedge then distributes an equal value of the vault’s SOL to Stability Pool stakers as compensation for the burnt USH.
This means liquidations on Hedge are slippage-free and are always completely performed at the oracle price of the collateral.
After paying back the Stability Pool, any remaining SOL in the vault is split up as liquidation rewards. 75% of this extra SOL goes to Stability Pool stakers as an extra reward, 20% goes to the HDG staking pool, and 5% goes to the user who initiates the liquidation.
Assume the vault from the previous example is liquidated. 10,000 USH gets burned, but 109 SOL = $10,900 has been claimed. 100 SOL = $10,000 will go directly to the Stability Pool as compensation, and the remaining 9 SOL will be split as liquidation rewards.
Of that 9 SOL excess:
- 75% = 6.75 SOL = $675 will also go to the Stability Pool
- 20% = 1.8 SOL = $180 will go to HDG stakers
- 5% = .45 SOL = $45 will go to the initiator
In all, Stability Pool stakers received 106.75 SOL worth $10,675, in exchange for 10,000 USH, a 6.75% return.
Since vaults are usually liquidated shortly after dropping below the collateral ratio threshold, the SOL distributed is usually worth more than the USH burned. Essentially, if you stake in the Stability Pool, you end up paying USH to buy SOL below the market rate without any slippage.
How much USH is taken from each Stability Pool staker, and how much SOL do they earn?
The pool divides both the USH burned and the SOL distributed between all the stakers in the pool, based on their proportional ownership of the total amount staked.
Continuing the above example:
If you owned 1% of the USH staked in the Stability Pool, 1% of the 10,000 USH burned would come from you, so you’d see your USH stake decrease by 100 tokens. Likewise, 1% of the 106.75 SOL distributed to the pool would go to you, giving you 1.0675 SOL, equal to $106.75.
As a caveat, in the rare case a vault dropped below a 100% collateral ratio, this would cause the SOL distributed to the Stability Pool to be worth less than the USH burned. In this case, the initiator of the liquidation receives 1% of the collateral as a reward, and the rest of the collateral goes to the Stability Pool.
However, under normal circumstances, competition for the rewards given to liquidators makes it likely for vaults to be liquidated well before this point.
What if my vault is liquidated?
As a vault owner, a liquidation will close your vault, erasing your debt and claiming your collateral. Though it’s not ideal, the situation isn’t as bad as it might seem: you get to keep any USH you took out from your vault, and you no longer have debt to repay.
If you owned the vault we liquidated in the previous examples, unfortunately, you lost your $10,900 of SOL. However, you were previously loaned 10,000 USH that you now get to keep. Overall, your losses are only $900 in this case, approximately 8% of your collateral. You can even trade that USH back into SOL if you want.
If you’ve used other lending platforms, it’s worth noting that Hedge’s liquidations behave differently than some others’. For instance, on some platforms a liquidation repays only part of your debt and a liquidation penalty is taken out of your collateral, while leaving that vault open. On these platforms, however, the liquidation threshold is usually at a higher collateral ratio so it’s easier to get liquidated.
How can I protect my vault from liquidation?
To protect your vault from liquidation, make sure your collateral ratio stays above the minimum threshold. For maximum safety, you can maintain collateral ratios above the system collateral ratio of the vault type, in case the system ever goes into Recovery Mode.
Although Hedge won’t let you directly take an action that lowers your vault’s collateral ratio below the minimum, if the price of SOL drops, your vault could end up undercollateralized. Maintaining a buffer between your collateral ratio and the minimum threshold will reduce the chance of liquidation.
As a tip, Hedge loans have 0% interest, so your debt doesn’t grow over time. That means if you don’t increase your loan or pull out collateral, the only factor that can lower your collateral ratio is a drop in the price of SOL.
Hedge is also showing you the price at which your vault can get liquidated as the “Liquidation Price” and it won’t change, so you just need to watch out if the price gets close to that value.
As an example:
If you borrow 10,000 USH against 220 SOL, your vault’s collateral ratio will stay above 110% as long as the price of SOL stays above $50. This liquidation price will never change without you explicitly changing your collateral or loan balances.
Why are liquidations important?
Liquidations protect the health of Hedge and the USH peg. Liquidations make sure each individual vault has enough collateral to back up their USH, and so overall, the total USH outstanding is less than the total collateral value stored in Hedge.
Hedge’s quick liquidation mechanism also allows us to set a lower minimum collateral ratio than other DeFi lending platforms, because liquidators will remove risky vaults from the system shortly after they hit the threshold.
Liquidation improvements to come
As Hedge continues to build, we’re excited about future enhancements we’ll be making to liquidations. Keep an eye out for improvements coming soon. We’re exploring ideas such as partial liquidations and notifications when your vault is close to liquidation.
We hope you now have a better understanding of how liquidations work and how to protect yourself from them.
Be sure to join our community on Discord and follow us on Twitter. We’d love to see you share what you’ve learned!