Liquidation Protocol

The liquidation protocol on CVEX is a crucial component designed to maintain market integrity, safeguarding both the liquidated trader and counterparty traders. Triggered when a trader's margin ratio exceeds 100%, indicating inadequate collateral, Clearance Bots initiate liquidation, which the protocol executes deterministically to reduce risk exposure.

This process of liquidation is implemented to minimise market disruption and ensures fair value realisation. Funds recovered from liquidation first address the trader's debts, with any surplus returned back to their account. For each position, the protocol employs three sequential liquidation methods:

1. Market Order Liquidation with residual Liquidation Fee increasing Default Fund;

2. Market Order Liquidation and utilising the Default Fund for loss coverage;

3. Counterparty Liquidation via the Auto Deleverage Queue as a last resort.

Market Order Liquidation executes a Fill-or-Kill order, instantly liquidating positions at the best available market price. If complete fulfilment is impossible, the order is cancelled. The protocol sets the liquidation order's limit price to limit market impact, typically within 2% of the current mark price. The sensitivity of this is driven from data provided by the Platform Operator. This approach ensures a fair liquidation price for the liquidated trader and preserves order book liquidity.

Liquidation Fee and Default Fund

When a trader's positions are liquidated due to insufficient collateral, a Liquidation Fee is imposed. Typically, this fee is 2% of nominal value of the liquidated positions and is allocated to the Default Fund. The Default Fund plays a crucial role in preserving market stability during periods of significant volatility or liquidity shortage. In situations where liquidation proceeds are inadequate to cover all liabilities, the Default Fund may be utilised to cover the shortfall. In other cases, it will be replenished from liquidation proceeds.

Additionally, a portion of the Liquidation Fee, usually 0.5% (set by the Platform Operator), is allocated as a reward to the Clearance Bot responsible for initiating the liquidation. This reward mechanism ensures prompt and competitive action among Clearance Bots, incentivising them to initiate liquidation processes timely, thereby maintaining overall market stability.

Counterparty Liquidation

In scenarios where Market Liquidation is unfeasible and the Default Fund cannot offset shortfalls, CVEX Protocol employs Counterparty Liquidation as its final resort. This process involves a deterministic algorithm that identifies and proportionally reduces opposing positions held by traders, thereby preserving market balance. Settlements between liquidated trader and counterparty traders occur at the prevailing mark price, ensuring fairness and resistance to market volatility.

Counterparty liquidations, while undesirable, are essential for upholding market integrity. While the protocol strives to minimise such events, their absolute elimination isn't feasible. However, the Default Fund significantly mitigates the risk of counterparty liquidations, transferring the burden of defaults from counterparties to the undercollateralised traders, thereby maintaining overall market stability.