Liquidations

Liquidations are a critical part of the Xylem Protocol that help maintain the stability and collateralization of the USDx stablecoin. They ensure that USDx remains overcollateralized even during market volatility.

How Liquidations Work

When a vault’s collateralization ratio falls below the liquidation threshold (105%), the liquidation process begins:

1. Liquidation Trigger: Oracle price feeds detect when a vault’s collateralization ratio falls below the liquidation threshold
2. Liquidation Auction: The protocol enables liquidators to purchase the vault’s collateral at a discount
3. Debt Clearing: The liquidator uses USDx to repay the vault’s debt
4. Revenue Distribution: A liquidation tax (15%) is applied and distributed between the protocol Reserve and liquidators

Liquidation Incentives

The protocol uses a dynamic incentive system to ensure liquidations happen efficiently:

1. Progressive Rebate: As a vault’s collateralization ratio drops, liquidators receive an increasing portion of the liquidation tax
2. Liquidation Subsidy: Below 124% collateralization, the protocol begins subsidizing liquidations to ensure they remain profitable
3. Duration Risk Mitigation: The protocol’s design minimizes the duration risk for liquidators who must purchase USDx elsewhere to close positions

Liquidation Curve

The protocol employs a profit-sharing function for BTC liquidators, designed to incentivize prompt action:

Liquidator's profit = [Vault_BTC - [Vault_BTC * liquidation_tax] + [Vault_BTC * liquidation_rebate]] / [Vault_Debt * USDx_mint_min_collat_ratio]

Where:

• Liquidation_tax = 15%
• Liquidation_rebate = a sliding function that increases as collateralization decreases
• USDx_mint_min_collat_ratio = 130%

Reserve Protection

The Xylem Reserve plays an important role in the liquidation process:

1. Bad Debt Coverage: If liquidation auctions fail to attract bidders, the Reserve can step in to clear bad debt
2. Protocol Solvency: The Reserve ensures the protocol remains solvent during extreme market conditions
3. Long-term Stability: A portion of all protocol revenue accrues to the Reserve to maintain adequate coverage

The exact shape of the liquidation curves and incentives will be subject to ongoing refinement and governance action to optimize the liquidation process across various market scenarios.