Liquidation Mechanism Design

Liquidation mechanism design is the process of creating the rules that trigger the forced sale of collateral when a borrower's position becomes under-collateralized. This is a critical component of lending protocols, ensuring that the system remains solvent even during periods of high market volatility.

The design must account for market microstructure, such as price slippage and oracle latency, to ensure that liquidations occur fairly and efficiently. Liquidators are typically incentivized by a bonus, which encourages them to act quickly to close risky positions.

If the mechanism is poorly designed, it can lead to bad debt or even a systemic collapse if liquidations fail to cover the shortfall. Effective design balances the speed of liquidation with the need to prevent unnecessary losses for borrowers during temporary market spikes.