An account whose margin percentage falls below the maintenance margin requirement (7.5%) may be liquidated. During a liquidation, the liquidator is allowed to take on the entire account balance of the liquidated account, leaving it with zero margin and position. Partial liquidation is also permitted, in which case the liquidator will take on proportional amounts of the account’s margin and position (one of which will be negative).
Liquidations occur on-chain, and any account may act as a liquidator, provided that their ending balance after the liquidation meets the maintenance margin requirement.
Since a liquidator may take on the liquidated account’s full balance, the incentive to liquidate is higher the closer the target account is to the liquidation threshold. Other factors impacting the liquidation reward are:
- Price direction and time to liquidation (e.g. account value may continue to fall, reducing the liquidation reward)
- Gas costs to win liquidation
- Costs of closing the liquidated position (in order to avoid taking on additional price exposure)
Assume an initial margin requirement of 10% and a maintenance margin requirement of 7.5%.
Trader A deposits 1000 USDC, then opens a short position of 1 BTC at a price of 2000 USDC. Their account balance is +3000 USDC, -1 BTC. The on-chain index price is 2000 USDC/BTC making their margin percentage 50%.
Over time, the price of BTC increases, and the on-chain index price hits 2791 USDC, at which point Trader A’s position is below the maintenance margin requirement and becomes liquidatable. Trader B, who has a balance of +100 USDC, 0 BTC, liquidates A’s position successfully, leaving A with zero balance, and bringing B’s balance to +3100 USDC, -1 BTC. Trader B then closes the short position on the market at a price of 2800 USDC, bringing their final balance to +300 USDC, 0 BTC.
At the time of liquidation, using the index price of 2791 USDC, Trader A’s account had a nominal value of 209 USDC, therefore we may say that A’s liquidation penalty was 209 USDC.
Trader B’s profit, after closing the short position, and ignoring any trade fees, is 200 USDC.
Example 2 - Partial Liquidation
Suppose Trader A has an account balance of +3000 USDC, -1 BTC, but due to a rapidly increasing price in the underlying spot market, the on-chain index is now 2900 USDC, giving A a margin percentage of only 3.45%.
Trader B, who has a balance of +100 USDC, 0 BTC, wants to liquidate Trader A’s account. However, at the current index price, a full liquidation is not possible since it would leave B with a margin percentage of 6.90%. Trader B chooses to execute a partial liquidation, taking on 60% of Trader A’s balances. This leaves A with 1200 USDC, -0.4 BTC, and B with 1900 USDC, -0.6 BTC.
At an index price of 2900 USDC, Trader B’s account has a nominal value of 160 USDC, giving them a hypothetical profit of 60 USDC. Trader B’s position is currently fairly risky however, with a margin percentage of 9.20%.
Trader A’s remaining position still has a margin percentage of 3.45%, and their remaining balance may be liquidated if they don’t make a deposit or trade out of their position.