Collateral Auction vs. Debt Auction Designs

Sells overcollateralized assets to cover bad debt. This design prioritizes system solvency by auctioning seized collateral (e.g., ETH, wBTC) to recoup value. It's effective for protocols with highly liquid, diversified collateral portfolios. The risk is liquidation cascades during market crashes if auction demand dries up.

Mints and auctions protocol-native tokens to recapitalize the system. This design protects the collateral base by minting new governance/stablecoin tokens (e.g., FLX) sold for assets to burn bad debt. It's optimal for maximizing collateral reuse and avoiding fire sales, but dilutes token holders and requires strong token demand.

Protocols with exogenous, liquid collateral. If your system accepts blue-chip assets (ETH, stETH, wBTC) and values immediate solvency settlement, this is the standard. It directly removes risky positions but requires robust liquidation engines and oracle resilience to prevent undercollateralized auctions.

Protocols prioritizing collateral efficiency or using volatile native tokens. Ideal for stablecoins like RAI or systems where protecting the exogenous collateral (e.g., ETH) is paramount. It's a more complex recapitalization tool that assumes a valuable, demand-elastic governance token exists to absorb the dilution.

Direct asset liquidation: Sells the undercollateralized asset (e.g., ETH) directly for a stablecoin to cover the bad debt. This preserves the protocol's native token supply and avoids dilution. Ideal for protocols like MakerDAO with deep, liquid collateral markets.

Exposed to market volatility: If the collateral asset's price is falling rapidly (a "cascade"), auctions may fail or settle at a loss, increasing the protocol's deficit. Requires robust liquidation engines and keeper incentives to ensure bids.

Mints and sells protocol tokens: To recapitalize the system, the protocol mints its own token (e.g., MKR, LQTY) and auctions it for stablecoins. This acts as a final backstop, effective when collateral markets are illiquid or frozen, as seen in Maker's global settlement mechanism.

Direct dilution pressure: New token minting dilutes existing holders and can create sell pressure on the native token, potentially creating a negative feedback loop. Requires strong tokenomics and community governance to manage, a key consideration for protocols like Liquity.

Direct asset recovery: Auctions off the undercollateralized asset itself (e.g., ETH, wBTC). This provides a clear, transparent price discovery mechanism for the collateral. Ideal for protocols with highly liquid, blue-chip assets where market depth exists (e.g., MakerDAO's Surplus Auction).

Market risk exposure: Success depends entirely on secondary market liquidity. During a black swan event (e.g., March 2020), collateral auctions can fail, leading to bad debt accumulation. Requires complex parameters (minimum bid, duration) to balance efficiency and safety.

Capital efficiency and stability: Auctions off protocol-native tokens (e.g., MKR, AAVE) to cover bad debt, effectively recapitalizing the system. This isolates the protocol from volatile collateral markets, providing a more predictable recovery path. Used by MakerDAO's Debt Auction (FLAP) for system surplus.

Protocol token dilution: Mints and sells new governance tokens, potentially diluting existing holders and depressing token value if used frequently. Requires a deeply liquid and valuable protocol token, which newer protocols may lack. Introduces circular dependency on the protocol's own economic health.