Liquidation Waterfall Mechanics

Liquidation waterfall mechanics refer to the systematic process of closing out under-collateralized positions in a derivatives protocol. When a user's margin drops below a maintenance threshold, the protocol triggers a series of actions to recover funds and protect the system.

First, the protocol may attempt to close positions through automated liquidators; if this fails or if the market lacks depth, it moves to the insurance fund. If the insurance fund is depleted, the protocol may initiate socialized losses, where other profitable traders share the burden of the deficit.

This waterfall is designed to ensure the protocol remains solvent, but it introduces significant uncertainty for users during extreme events. Understanding the order and impact of these mechanisms is vital for assessing the systemic risk of a platform.