Liquidations are one thing that the whole DeFi running on Ethereum has to face in one way or another. The closing of a position must be triggered outside the blockchain; that is to say, some party must take action to close or liquidate a position.
As IPOR interest rate swaps have a set maturity, they must be exercised at some point. Swaps may also run into situations where the whole collateral is used up, and the derivative would enter negative equity. Efficient liquidations, therefore, are a must under those conditions.
The question is: how to enable liquidations without putting a high burden on the trader? At the inception of the IPOR Protocol, DAO opted for a liquidation deposit as we see this as the fairest and most efficient way to handle the process. Money markets usually allow liquidation of position at a hefty discount to incentivize liquidators to move quickly when high volatility may push loans' collateral to be worth less than it secures in a couple of minutes. With IPOR Swaps, since they are similar to vanilla swaps used in traditional markets, even at very high volatility, the derivatives are not affected to nearly the same extent since they are an exchange of cash flows over time. Therefore the protocol can allow even higher cash efficiency and let the derivative use its collateral to the very last cent.
A refundable liquidation deposit is charged at the time of opening the swap. The amount of the deposit is fixed and set by the governance. The reason for charging the deposit is to make sure that there is an incentive for the trader to liquidate their derivative or for a community liquidator to do it instead of the derivative owner. The IPOR AMM allows multiple derivatives to be liquidated simultaneously, which should further help with the gas efficiency of such a procedure.
Closing Your Derivative
An interest rate swap can be closed at any time by the trader who has opened it. If the interest accrued is positive, in other words, the trader has made money on the swap; they will receive more than they initially put in. Otherwise, the interest payoff would be deducted from the trader's collateral and transferred to the liquidity pool. In any case, the liquidation deposit would be paid back to the user's Ethereum address along with the calculated payoff.
A derivative becomes available for liquidation when:
It reaches maturity in 6 hours
It has generated a 99% profit or loss
Any community member can call a function to close the swap that meets these criteria within a certain threshold. The liquidator will be rewarded with the stablecoin that has been set aside as a liquidation deposit. That stablecoin reward will be transferred directly to the liquidator's Ethereum address.
The reason behind allowing liquidations slightly before the maturity and 100% profit or loss is to remove friction from liquidations and increase the possibility that there might be more than one liquidation to perform at a time.
Liquidation of last resort
If the derivative reaches maturity or 100% profit or loss, the community liquidation is handed over to the DAO-appointed last-resort liquidators. At this time, the owner of the derivative can also close it and collect their liquidation deposit.