A liquidation is a process that occurs when a borrower's health factor goes below 1 due to their NFT collateral value not properly covering their debt value. This might happen when the NFT collateral decreases in value or the borrowed debt increases in value against each other. This collateral vs loan value ratio is shown in the health factor.
When any position is liquidated, liquidators are allowed to purchase any NFT collateral of the borrower at a discount price. The discount ratio is equivalent to the liquidation bonus. Then the funds will be used to repay the borrower's debt. This process can be conducted continuously until the borrower's health factor goes above 1. In a liquidation, if the value of the NFT collateral taken by the liquidator exceeds the value of the debt, any excessive fund will be returned back to the NFT collateral owner's address.
The liquidation pool play an important role as one of the liquidators. It is the first line of defense in maintaining system solvency. It achieves that by acting as the source of liquidity to repay debt from liquidated position—ensuring that the total debt always remains backed by the NFT collateral. The liquidation pool is funded by liquidity providers who deposit loan assets to the pool for the liquidation bonus.
When any position is liquidated, the liquidation pool is allowed to purchase any NFT collateral of the borrower at a discount price, then the funds will be used to repay the borrower's debt. This process will continue until the borrower's health factor goes above 1. In a liquidation, if the value of the NFT collateral taken by the liquidation pool exceeds the value of the debt, any excessive fund will be returned back to the NFT collateral owner's address.
After the liquidation completes, these NFT collateral will be auctioned in public marketplaces. In the first 12 hours of the auction, the NFT will be sold to the highest bidder with discount price as the reserve price. If the auction ends without a sale, in the next 12 hours the auction will take place in the form of Dutch Auction with the market price as the top price and the discount price as the bottom price, where the price falls until someone purchases.
After the auction completes, the fund is taken by the liquidation pool to supplement liquidity and the profit is distributed to liquidity providers as incentives. If the auction fails, the NFT collateral becomes bad debt of the liquidation pool, and the liquidity providers may suffer loss.
If the liquidity of the liquidation pool is not enough to cover the debt of the protocol, Vinci will auction reserved VCI tokens to support.