Forced Redemption

A forced redemption is initiated automatically by smart contract logic when predefined conditions are met. Common triggers include:

• Loan-to-Value (LTV) breach: When collateral value falls below a maintenance threshold.
• Protocol insolvency: To cover bad debt during extreme market volatility.
• Security or governance mandate: In response to a hack, bug, or passed governance vote.

While both close positions involuntarily, they differ in execution and purpose.

• Liquidation: Typically a third-party (keeper) buys undercollateralized assets at a discount in an open market auction. The protocol is made whole, and the keeper profits.
• Forced Redemption: The protocol itself directly settles the position, often at a fixed price or oracle price, without a discount auction. It's used for non-collateral-related term enforcement.

This mechanism appears in several key DeFi primitives:

• CDP / Lending Protocols (e.g., MakerDAO): Liquidates vaults when collateralization drops.
• Algorithmic Stablecoins (e.g., older models): Redeems supply to maintain peg during contraction phases.
• Tokenized Funds / Vaults: Allows redemption at Net Asset Value (NAV) to prevent persistent discounts.
• Derivatives Protocols: Settles expired perpetual contracts or options.

The redemption price is not set by the market but by the protocol's rules. Critical methods include:

• Oracle Price: Uses a decentralized oracle (e.g., Chainlink) for a fair market value snapshot.
• Fixed Formula: Applies a predetermined penalty or haircut to the oracle price.
• NAV-based: In funds, uses the calculated Net Asset Value per share. Reliable price feeds are essential to prevent manipulation and ensure fairness.

Forced redemptions are a core risk management tool, but introduce their own risks.

• Pros: Protects protocol solvency, enforces terms, and can stabilize token pegs.
• Cons: Can cause cascading liquidations in volatile markets, leading to death spirals. May be perceived as punitive if not transparently governed. Design choices around triggers, penalties, and time delays are critical for stability.

Parameters governing forced redemptions are typically set and adjustable via decentralized governance. This includes:

• Setting LTV ratios and liquidation penalties.
• Whitelisting or adjusting oracle feeds.
• Pausing the mechanism in emergencies. Transparent, on-chain governance and clear documentation are vital for user trust and protocol resilience.

The most common trigger is when a borrower's collateralization ratio falls below the protocol's liquidation threshold. This occurs due to price volatility. To protect lenders, the protocol forcibly sells the collateral to repay the debt, often via a liquidation auction or a fixed discount sale to keepers.

• Example: In MakerDAO, a Vault becomes eligible for liquidation if its collateral value drops too low relative to its DAI debt.

Algorithmic or collateralized stablecoins use forced redemption to maintain their peg. If the market price falls significantly below the target (e.g., $1), the protocol may allow anyone to redeem one stablecoin for $1 worth of underlying assets, arbitraging the price back up.

• Mechanism: This is often executed through a redemption contract that burns the stablecoin and sends the pro-rata collateral to the redeemer.

If a protocol accrues unrecoverable bad debt (e.g., from undercollateralized positions after a market crash), it may trigger a forced redemption of a governance token or a recapitalization process. This dilutes existing holders or uses treasury assets to cover the shortfall and restore solvency.

• Example: Some lending protocols have safety modules where staked tokens can be slashed to recapitalize the system.

Protocols with centralized elements or operating in regulated jurisdictions may be compelled to forcibly redeem or freeze assets belonging to addresses on sanctions lists (e.g., OFAC). This is typically enforced via an upgradable contract or a privileged admin function.

• Controversy: This use case highlights the tension between censorship resistance and regulatory compliance in DeFi.

In yield aggregators like Yearn Finance, a strategy may be shut down due to excessive risk, low profitability, or a discovered vulnerability. Users' funds are forcibly redeemed from the strategy and returned to the vault, allowing for withdrawal or deposit into a new strategy.

• Process: This is a protective measure managed by governance or strategists to safeguard user capital.

Some protocols use a two-phase auction system. After a forced liquidation creates a surplus (collateral sold for more than the debt), that surplus is used to buy back and burn the protocol's stablecoin or governance token in a reverse auction. This creates deflationary pressure and strengthens the system's balance sheet.

A forced redemption is typically triggered by predefined on-chain conditions or a governance vote. Common triggers include:

• Risk Management: A collateral position falling below the maintenance margin.
• Protocol Shutdown: An orderly wind-down of a protocol or fund.
• Regulatory Action: Compliance with legal demands, such as freezing sanctioned addresses.
• Security Breach: Containing the impact of an exploit by redeeming vulnerable assets. The process is usually automated via smart contracts, removing discretionary human intervention.

This power introduces centralization risk, as it often relies on a privileged actor or multi-signature wallet. Key concerns include:

• Admin Key Compromise: If the private key controlling the redemption function is stolen, an attacker could liquidate user positions maliciously.
• Governance Capture: A malicious actor could acquire enough voting power to trigger redemptions for personal gain.
• Opaque Triggers: If conditions are not fully transparent and verifiable, users cannot accurately assess their risk exposure.

Forced actions directly affect user funds and can be perceived as unfair. Critical considerations are:

• Slippage & Pricing: A mass redemption can cause significant price impact, resulting in users receiving less value than expected.
• Order of Operations: The sequence in which positions are redeemed (e.g., FIFO, pro-rata) must be clearly defined to prevent front-running or inequitable outcomes.
• Notification: Protocols often struggle to provide adequate warning to users before a forced action is executed.

Robust governance is essential to legitimize forced redemptions. Best practices include:

• Time-Locked Functions: Implementing a delay on redemption execution after a governance vote, allowing users time to exit.
• Transparent Parameters: Clearly publishing all thresholds, formulas, and conditions that can trigger the action in the protocol's documentation and smart contracts.
• Multi-Signature Safeguards: Requiring approval from a diverse set of independent parties to execute, reducing single points of failure.

Forced redemptions intersect with securities law and financial regulations. Key implications are:

• Security Classification: Aggressive redemption features may cause a token to be classified as a security, as it implies a centralized entity managing an investment contract.
• Fiduciary Duty: Protocols or DAOs exercising this power may inadvertently assume fiduciary responsibilities toward their users.
• Enforceability: The legal standing of an on-chain forced action, especially across jurisdictions, remains largely untested.

A risk management process where an undercollateralized loan position is automatically closed. A liquidator repays the borrower's debt in exchange for their collateral at a discount, ensuring the protocol remains solvent. This is distinct from forced redemption, which typically targets overcollateralized positions to manage protocol exposure or peg stability.

• Trigger: Collateral value falls below a maintenance ratio.
• Actor: Third-party liquidators (often bots).
• Example: A MakerDAO Vault being liquidated if ETH collateral drops too low.

A mechanism used by collateralized debt position (CDP) protocols like MakerDAO to recapitalize the system after a liquidation shortfall. When collateral from a liquidation is insufficient to cover the bad debt, the protocol mints and auctions off governance tokens (e.g., MKR) to raise the necessary capital. This restores the system's solvency.

• Purpose: Cover system bad debt.
• Asset Sold: Protocol's governance token.
• Contrast: Forced redemption directly removes debt and collateral from circulation, while debt auctions mint new tokens to cover deficits.

The inverse of a debt auction. When a protocol like MakerDAO has excess capital in its system surplus buffer (e.g., from liquidation penalties), it auctions off stablecoins (e.g., DAI) in exchange for its governance tokens (MKR), which are then burned. This manages excess capital and can be a precursor or alternative to forced redemption actions.

• Purpose: Reduce system surplus and burn governance tokens.
• Asset Sold: Protocol stablecoins (e.g., DAI).
• Relation: Both surplus auctions and forced redemptions are tools for managing a protocol's balance sheet and token supply.

An emergency shutdown procedure that permanently freezes a protocol, allowing users to redeem their collateral directly at a fixed, final price. It is the ultimate circuit breaker, triggered in cases of severe attack, long-term market failure, or governance decision. Users can then claim the underlying collateral for their tokens.

• Nature: Final, irreversible shutdown.
• Trigger: Governance vote or emergency oracle failure.
• Scale: Forced redemption can be a targeted tool, while global settlement is a complete termination of the system.

The variable interest rate accrued on debt positions in CDP protocols. It is a primary tool for regulating the supply and demand of a protocol-issued stablecoin (like DAI). By adjusting this fee, governance can incentivize or disincentivize the creation of new debt, indirectly influencing conditions that might later necessitate a forced redemption.

• Function: Monetary policy lever for stablecoin supply.
• Mechanism: Paid in the protocol's governance token or stablecoin.
• Connection: High stability fees can reduce outstanding debt, potentially making forced redemption less likely.

The key risk metric for any collateralized position, expressed as (Collateral Value / Debt Value) * 100%. Protocols set minimum liquidation and target ratios. Forced redemptions often target positions that, while above the liquidation ratio, have fallen below a higher target or risk-adjusted threshold defined for system-wide risk management.

• Liquidation Ratio: Minimum level to avoid liquidation.
• Target Ratio: Optimal level for system health.
• Usage: Forced redemption criteria are often based on deviations from target collateralization levels for specific asset classes.