Collateral Auction

A collateral auction is triggered when a loan's collateralization ratio falls below the liquidation threshold. The protocol seizes the user's collateral and auctions it off, typically for the protocol's stablecoin (e.g., DAI, USDC). The goal is to raise enough to repay the loan's principal plus a liquidation penalty, with any surplus returned to the borrower. Common auction types include English auctions (price increases) and Dutch auctions (price decreases).

The system relies on keepers (liquidators) to participate. They are incentivized by a liquidation bonus (or discount) on the collateral. For example, a 10% bonus means a keeper can buy $100 worth of collateral for $90 of debt. This creates a competitive market to ensure timely liquidations. Protocol stability depends on keeper profitability aligning with market conditions to prevent liquidation cascades.

If the auction fails to raise enough to cover the debt, the protocol incurs bad debt, which is often socialized or covered by a surplus buffer. Another major risk is Maximal Extractable Value (MEV), where sophisticated bots use advanced strategies like sandwich attacks or time-bandit attacks to outbid ordinary users, centralizing liquidation profits and potentially destabilizing the auction's fairness.

Critical parameters controlled by protocol governance include:

• Liquidation Ratio: Minimum collateral value to debt value.
• Liquidation Penalty: Fee added to the debt.
• Auction Duration: Time limit for the sale.
• Minimum Bid Increment. Setting these requires balancing system safety against user convenience. Overly aggressive settings can trigger unnecessary liquidations, while lenient settings increase systemic risk.

Unlike a fixed spread liquidation (common in CEXs and some lending protocols), where collateral is instantly sold at a fixed discount, auctions aim for price discovery. Fixed spreads are simpler but can be inefficient during high volatility, potentially leaving bad debt. Auctions are more complex but can achieve better prices for the protocol and the borrower, especially for large or illiquid collateral positions.

The process of selling a borrower's collateral to repay their debt when their position becomes undercollateralized (falls below the required collateralization ratio). This is the event that triggers a collateral auction. Key aspects include:

• Liquidation Threshold: The specific collateral value ratio that triggers the process.
• Liquidation Penalty: A fee added to the debt, paid to the liquidator as an incentive.
• Health Factor: A common metric (e.g., in Aave, Compound) that determines liquidation risk.

A complementary mechanism used by some protocols (like MakerDAO) when a collateral auction fails to cover the bad debt. Instead of selling collateral for a fixed amount of stablecoin (DAI), the protocol mints and auctions its governance token (MKR) to raise the needed capital. This is a reverse auction where participants bid the lowest amount of MKR they will accept in exchange for covering a fixed amount of bad debt.

An auction used by overcollateralized protocols to manage excess capital in the system. When fees accumulate or collateral is sold at a premium during liquidations, the resulting surplus (e.g., extra DAI in Maker's Surplus Buffer) is auctioned off. Participants bid governance tokens (MKR) to buy this surplus at a discount, with the purchased tokens then being burned, creating a deflationary pressure on the governance token.

The key metric that determines the safety of a loan and the trigger for liquidation. It's calculated as (Value of Collateral / Value of Debt) * 100%.

• Minimum Ratio: The lowest allowed ratio before liquidation. For example, 150% means $150 of ETH collateral for $100 of borrowed DAI.
• Maintenance Margin: A similar concept in perpetual futures markets.
• Loan-to-Value (LTV): The inverse concept; the maximum amount you can borrow against collateral (e.g., 66.6% LTV = 150% collateralization ratio).

An automated agent or bot that monitors the blockchain for undercollateralized positions and executes liquidation transactions. Keepers are essential for the auction system's efficiency. They:

• Compete to be the first to call the liquidation function, earning the liquidation penalty.
• Must calculate gas costs and profitability in real-time.
• Use sophisticated MEV (Maximal Extractable Value) strategies, sometimes leading to gas auctions where they bid up transaction fees to win the liquidation.

A common format for collateral auctions, also known as a descending price auction. The auction starts with a high asking price for the collateral lot, which decreases over time until a bidder accepts the current price. This design:

• Encourages rapid settlement by creating urgency for bidders.
• Aims to discover the market price efficiently in a low-liquidity scenario.
• Is used by MakerDAO's Collateral Auction Module (FLIP) and other protocols to sell seized collateral.