Risks
Borrower Default
Backpack has a tiered liquidation model that prevents your account from going bankrupt. First, the system attempts to liquidate positions through the orderbook. If positions are too large or if a user's margin fraction falls below their auto-close threshold, liquidation occurs against Backstop Liquidity Providers.
In the edge case that prices are falling extremely rapidly and the system is not able to liquidate a borrower’s position on time, Backpack employs an auto-deleveraging (ADL) mechanism to ensure that the lender receives the value of their lend in notional terms. To illustrate this:
Assume a Borrower is borrowing 1 BTC from a Lender
Borrower is not holding BTC in their account. They either withdrew it or traded it into another asset.
The Borrower’s account goes bankrupt. BTC is trading at $100,000.
The Lender is still expecting their money. In this edge case, the liquidation system would liquidate the Borrower’s assets, and pay out $100,000 to the Lender in notional terms, rather than 1 BTC.
In conclusion, Backpack’s liquidation system has levels of backstop liquidity in place to maintain stability in the market and protect lenders. In extreme cases, the primary mandate of the margin system is to make sure that the Lender receives the value that they lent, either in the actual token or in notional USD terms at the time of liquidation.
100% Utilization
When a market reaches 100% utilization, lent assets cannot be redeemed. This creates a potential risk since Backpack allows lent assets to be used as collateral. If a user with lent collateral faces liquidation, but their assets cannot be redeemed due to full utilization, Backpack employs an Auto-Deleveraging (ADL) mechanism.
The ADL process works as follows:
A user with lent assets as collateral triggers liquidation due to losing positions.
Market utilization reaches 100%, preventing lend redemptions.
The liquidation engine activates but cannot redeem the lender's assets.
The system matches the lender with borrowers who have available collateral (every borrow is collateralized).
An amount in notional USDC terms no greater than the size of the original borrow is transferred from the borrower to the lender's account for liquidation.
The loan is now closed. The lender was successfully liquidated. The borrower's collateral may have been converted to a different asset than originally borrowed, but their account value remains unchanged.
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