Forced Liquidation Auction

A forced liquidation auction is a mechanism used by protocols to sell off a liquidated user's collateral to repay their outstanding debt. When a position is liquidated, the protocol needs to convert the collateral into the asset that was borrowed to maintain the balance of the lending pool.

This is typically done through a Dutch auction or a sealed-bid auction process. Participants, often called liquidators, compete to purchase the collateral at a discount, which incentivizes them to act quickly and restore the protocol's solvency.

The discount serves as a reward for the liquidator's role in managing system risk. These auctions are crucial for efficient price discovery during periods of market stress, as they allow for the rapid reallocation of assets.

They also ensure that the protocol remains neutral and does not hold unwanted assets for long periods. This process is a core component of the lifecycle of a distressed position in DeFi.