Soft Liquidation

Unlike a traditional hard liquidation that closes a position in one transaction, a soft liquidation sells collateral in small, partial chunks. This process continues until the loan's health factor is restored to a safe level above the liquidation threshold. This reduces market impact and gives the borrower time to react.

The process is triggered when a loan's Health Factor (HF) falls below 1.0, indicating undercollateralization. A soft liquidation system will have a soft liquidation threshold (e.g., HF < 1.0) where partial selling begins, and a lower hard liquidation threshold (e.g., HF < 0.95) for full closure if the gradual process fails.

• Key Metric: Health Factor = (Collateral Value * Liquidation Threshold) / Borrowed Value

By selling collateral incrementally, the mechanism minimizes slippage and avoids flooding the market with a large sell order. This protects both the borrower (getting a better average price) and the lending protocol's liquidity pool from sudden, destabilizing draws on reserves.

The incremental nature creates a grace period. The borrower can intervene by:

• Adding more collateral to increase the Health Factor.
• Repaying part of the debt directly. This allows users to save their position without it being fully liquidated, a key improvement in user experience over binary systems.

Liquidators are incentivized to participate by a liquidation bonus (or penalty) taken from the borrower's collateral. In a soft system, this bonus is applied to each incremental sale. Protocols must carefully calibrate this bonus to ensure liquidator profitability while minimizing cost to the borrower.

Unlike a hard liquidation that closes the entire position and charges a significant penalty fee (e.g., 10-15%), a soft liquidation sells or unwinds only the necessary collateral to restore the health factor. This minimizes the financial penalty for the borrower, preserving more of their capital.

The primary goal is to avoid a complete, disruptive exit. The mechanism allows borrowers to retain partial exposure to their leveraged position after the health factor is restored, enabling them to benefit from potential market recovery without needing to re-enter the trade.

By selling collateral in smaller, incremental portions, soft liquidations reduce large, sudden sell pressure on the underlying asset. This helps stabilize markets during volatility by preventing the cascading liquidations often seen in systems with fixed, large liquidation thresholds.

Lenders (liquidity providers) benefit from reduced protocol insolvency risk. The gradual, partial unwinding ensures loans remain overcollateralized more consistently, protecting the lending pool's solvency without relying on third-party liquidators to bid on large, discounted positions.

The less punitive nature reduces user attrition. Borrowers are less likely to be completely wiped out by a minor price dip, leading to a better experience and higher protocol retention rates compared to the 'all-or-nothing' stress of traditional systems.

Liquidity providers (LPs) in soft liquidation systems bear the primary risk. When a position is gradually unwound, LPs acquire the undercollateralized asset at a discount, exposing them to its price volatility. This creates a form of impermanent loss if the asset's price continues to decline. The protocol's health is maintained by transferring risk from the borrower to the LP pool.

Determining the correct health factor thresholds, discount rates, and unwind speed is highly complex. If parameters are too aggressive, it mimics a hard liquidation; if too lenient, bad debt can accumulate in the system. This requires sophisticated, real-time risk models that must adapt to changing market volatility and liquidity conditions.

The mechanism's effectiveness is entirely dependent on sufficient liquidity depth in the associated pools. In a market crash or low-liquidity environment:

• The gradual sell-off can cause significant slippage, worsening losses for LPs.
• The process may fail to close the position fully, potentially leading to a traditional hard liquidation event anyway.

The predictable, multi-step nature of a soft liquidation creates new Maximal Extractable Value (MEV) opportunities. Searchers can front-run the liquidation transactions to buy the discounted assets before the protocol's orders, reducing the effectiveness of the mechanism and potentially increasing costs for the borrower or LPs.

A slow, partial unwind can mask the true extent of an undercollateralized position. If asset prices fall rapidly, the soft liquidation may not keep pace, allowing the loan-to-value (LTV) ratio to deteriorate further before the position is fully closed. This can result in a larger final deficit than a swift, full liquidation would have created.

Compared to a simple, one-transaction hard liquidation, soft liquidation requires more complex smart contract logic, oracle integrations for pricing, and often a dedicated keeper network or sequencer to execute the multi-step process. This increases gas costs, attack surface, and protocol maintenance burden.

The core metric that triggers a soft liquidation. It's a ratio comparing the collateral value to the borrowed value, adjusted for asset risk. When the HF falls below a protocol's liquidation threshold (e.g., 1.1), the position becomes eligible for soft liquidation. This acts as an early warning system, allowing for partial deleveraging before insolvency.

The specific Health Factor value at which a position is considered undercollateralized and can be liquidated. This is set per collateral asset based on its volatility and liquidity. For example, a stablecoin might have a threshold of 1.1, while a more volatile asset might be 1.3. It defines the buffer zone where soft liquidation operates to avoid crossing the more severe liquidation close factor.

The traditional liquidation process that soft liquidation aims to improve upon. Key differences:

• Trigger: Position becomes severely undercollateralized (HF ≤ 1.0).
• Execution: The entire borrowed position is closed at once.
• Penalty: A significant liquidation penalty (e.g., 10-15%) is applied to the debt.
• Impact: Causes large, sudden losses for the borrower and can create market volatility. Soft liquidation mitigates these downsides.

In traditional systems, this defines the maximum percentage of a borrower's debt that can be liquidated in a single transaction. Soft liquidation mechanisms often bypass or modify this by allowing for smaller, incremental liquidations (e.g., liquidating just enough to restore the HF above the threshold) rather than being bound by a fixed close factor percentage.

A related but distinct mechanism used primarily in perpetual futures exchanges. When insurance funds are depleted, profitable positions on the opposing side are automatically reduced to cover losses from liquidated traders. Unlike soft liquidation, which sells a borrower's collateral, ADL closes the positions of profitable traders, sharing the loss burden across the system.

A complementary risk tool often used alongside soft liquidation protocols. As utilization of a lending pool increases or market volatility rises, protocols can algorithmically increase borrow interest rates. This disincentivizes further borrowing and encourages voluntary repayment, helping to prevent positions from reaching liquidation thresholds in the first place.