Each collateral asset in the Notional system can be liquidated to re-collateralize an under-collateralized account.
Liquidators can purchase cTokens in a currency where the account has a collateral surplus in exchange for cTokens in a currency where the account has a collateral requirement.
Liquidators can purchase nTokens in a currency where the account has a collateral surplus in exchange for cTokens in a currency where the account has a collateral requirement.
Liquidators can purchase fCash in a currency where the account has a collateral surplus in exchange for cTokens in a currency where the account has a collateral requirement.
Liquidators can force the account to convert their liquidity tokens into their underlying cToken and fCash claims. This lowers the risk of the account's portfolio, reduces the impact of the liquidity token haircut, and increases the collateral surplus (or decreases the collateral requirement) in the liquidity token currency.
Liquidating liquidity tokens does not require the liquidator to purchase or deliver any asset. So in practice this type of liquidation is folded into cToken and nToken liquidations.
This account is under-collateralized. A liquidator can purchase a portion of this account's cETH in exchange for cDAI at a discount to the on-chain oracle price. This action decreases the effect of the exchange rate buffer and improves the account's collateral position.
Notional will allow liquidators to purchase as much of an account's cToken balance as is necessary to return that account to minimum collateralization levels. As a default though, liquidators can purchase 40% of an account's cToken balance even if that results in significant overcollateralization for the account post-liquidation. Finally, Notional allows liquidators to specify a maximum amount of collateral that they are willing to purchase in any liquidation if they so choose.
In this example, let's assume that the liquidator has not specified a max liquidation amount.
- Default liquidation portion: .4 ETH (.4 * 1 ETH)
- Liquidation price: 376 ETH/DAI (.94 * 400 ETH/DAI)
- Liquidator purchases .4 ETH for 150.4 DAI
This liquidation has decreased the account's exchange rate risk by evening out its local currency collateral values. The value of this account is roughly 40% less exposed to changes in the ETH/DAI exchange rate. As such, its free collateral has improved to a positive value.
Liquidating nTokens or fCash works similarly to liquidating cTokens. Because the value of an account's nTokens and fCash rolls up into its local currency collateral value during the free collateral calculation, an liquidating either of these assets will even out its local currency collateral values and decrease the account's exchange rate risk.
But liquidation provides an additional benefit in both of these cases by releasing the haircut associated with holding nTokens or fCash instead of cTokens. In other words, it increases the local currency collateral value of the nToken or fCash currency in addition to decreasing the account's overall exchange rate risk.