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With the way the liquidity pool is designed, one can argue that there is not really a risk of bad debt from a delay in liquidation. This claim is best illustrated by an example
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Example1:
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Assets in the liquidity pool: (Please note that assets can be in any ratio)
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9 BTC
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100 ETH
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100,000 USD
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1.) Alice deposits 1 BTC as collateral and opens a 5x long BTC position. At this time, BTC price is 20,000
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Assets in the liquidity pool becomes
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10 BTC (with 5 BTC reserved for Alice’s position - no actual token transfer, just a ledger record)
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100 ETH
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100,000 USD
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2.) Some time later, the price of BTC has fallen by 20% and so Alice should be liquidated
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Assets in the liquidity pool becomes
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10 BTC (the 5 BTC reserved for Alice is released back to LPs)
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100 ETH
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100,000 USD
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It is clear from above that even if the liquidation happened a little later when BTC price has dropped beyond 20%, LPs wouldn’t have suffered “bad debt” because they would still have 10 BTC at the end.
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The only “bad debt” scenario would be if the utilization was at 100% -i.e., all BTC were reserved for paying out profit. In this case, you could argue that if they weren’t reserved, the free-floating BTC could have potentially been swapped into another asset such as stablecoin prior to a price drop, leaving LPs with slightly higher USD value.
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With this in mind, we can actually make the liquidation threshold really high - e.g. 99% and there is not really a risk in offering very high initial leverage to users.
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