FlareLoans is a decentralized stablecoin issuance and loan platform currently running on the Songbird Network with future deployment on Flare Network post-launch. FlareLoans currently exists as an application within the ExFi v2 ecosystem launched as a real-world testing ground on the Songbird Network. Later on, FlareLoans will be part of the Songbird Finance (rebrand of ExFi v2) and Flare Finance ecosystems on each respective network. FlareLoans is a forked version of the Liquity Protocol that launched on Ethereum in Spring of 2021. With the exposition out of the way, let us dive into what redemptions and liquidations function as within the FlareLoans application.
As FlareLoans acts as a stablecoin issuance protocol, it is highly important that each stablecoin issued is backed with $1 in collateral for every stablecoin issued. Additionally, the stablecoin must be able to maintain a consistent peg around $1 for it to be widely used. Liquidations and redemptions both play an important role in these two main goals of a stablecoin issuance platform. As most decentralized stablecoins issued are backed by cryptocurrency collateral, FlareLoans must have adequate measures built into its protocol to maintain its stablecoin peg to USD value and solvency of the entire protocol.
Liquidations are a mechanism by which the FlareLoans application can maintain solvency. The base parameter to ensure proper liquidation of insufficiently collateralized loans is that any collateralized debt position (CDP) that falls below a collateralization ratio (CR) of 110% is at risk of immediate liquidation. This provides a buffer to ensure that the system can liquidate positions prior to them falling below a 1:1 backing for the stablecoin in extreme situations of mass liquidation due to sharp, downward volatility in the value of the underlying collateral.
We can break down the effects of this with an example. Let’s imagine that I have opened a CDP on the FlareLoans application on Songbird Network. Additionally, we will use the assumption that 1 CAND (stablecoin) is equal to 2 SGB (collateral asset), when I opened the position. Upon opening the position, I post 5k SGB as collateral at a value of $2,500 and take out a loan of 2k CAND valued at $2,000. My collateral ratio would be 125% ($2,500 collateral value / $2,000 loan value). Currently, this means my position is safe from liquidation; however, if the price of my collateral, SGB, were to fall to a value of $2,200, then my position would be at risk of liquidation. The price of SGB would need to fall from roughly $.50 to $.44, which would be the position’s liquidation price. In the scenario, I am liquidated here. I would lose all of my SGB collateral valued at $2,200 ($.44 * 5k SGB); however, I would retain the borrowed CAND valued at roughly $2,000. This means my loss from liquidation is around 10% as I lost $2,200 in collateral value but retained $2,000 in stablecoin value.
Its important to note here that this example assumes that I have not lost or gained on any of the borrowed value. If I had swapped that borrowed CAND for SGB, then it would be safe to assume that potentially my current losses would be larger than just 10% as the asset I swapped into has lost value as well and may no longer be worth $2,000. Additionally, I could not be at a true loss if let’s say I was using the CAND to earn yield which had netted me more than $200 to date.
Alright now that we have covered liquidations, we can dive into redemptions and how they can effect the balances of your CDP. Redemptions are purely a mechanism to ensure a solid price floor for the FlareLoans stablecoin. It incentivizes users to return stablecoins to the protocol in return for collateral from existing nests. The idea here is that if the stablecoin is trading below its $1 peg the system can provide incentives to lower the supply of its stablecoin in order to raise the value back to the peg. If a user currently has a CDP within FlareLoans and have a redemption occur against that position, the user does not incur a net loss. However, they do lose exposure to the collateral asset that was redeemed against.
As an example, let’s use the values from our position earlier on liquidations. We will also assume the redemption closes our entire position. Redemptions happen to the lowest collateralized CDP first and then work their way up from there. If my CDP is redeemed against in full and the price of my collateral is at $.50 per SGB, then the position would no longer be open. My 2k CAND debt would be erased in return for 4k SGB in collateral going to the redeemer. In this situation, I keep 1k SGB valued at $500 and all my borrowed funds valued at $2,000 (caveat of no net gain or loss on the borrowed funds). Considering, the collateral we had was valued at $2,500 originally and I still have $2,500 ($500 SGB and $2,000 CAND) there has been no change in value owned. While this example covers a full redemption on my CDP, it is possible to only have the position partially redeemed against as well. This would result in less CAND owed back to the system and less collateral remaining. No loss occurs in this situation as well since its a 1 for 1 trade off.
Users who conduct redemptions are incentivized to redeem CAND for collateral when the value of CAND is trading for less than $1. Redemptions allow users to swap CAND back to the system at face value ($1), so they can make a risk free profit (i.e. arbitrage). If I have 2k CAND trading on open market for $.98 per CAND, then I would be better off swapping CAND through the redemption mechanism than swapping on an open market like FlareX until the peg comes back in line with USD. If I redeem SGB collateral valued at $.50 per SGB with 2k CAND, then I receive 4k SGB valued at $2,000 on the open market. If I were to swap the same CAND on the open market at price of $.98 per CAND for SGB at price of $.50, then I would would receive 3,920 SGB valued at $1,960. The $40 difference less any fees in the process is the profit I make on redeeming CAND while it is trading below $1.
Individuals can redeem CAND when the price is over $1 per CAND; however, they would incur a loss for doing so as they could have swapped the higher value CAND on the open market for more SGB in return. This is because the FlareLoans protocol always values CAND at face value irregardless of the open market value, which creates the mechanisms for maintaining the stabelcoin peg to USD.
FlareLoans has a safety mechanism called Recovery Mode when the system total collateral ratio (TCR) falls below 150%. If your CDP CR is below the TCR when the protocol is in recovery mode, then you can suffer liquidations above CR of 110%. If you are worried about facing a liquidation or redemption on your position, then best practice would be to always maintain a CR above the system TCR. Additionally, please find the documentation on Liquity Protocol and FlareLoans below.
Thanks for reading! Additionally, we are unable to manage comments on our website due to the massive amount of spam that comes with allowing them. Therefore, please do not expect to get any additional questions answered from us via this post. Also, please be careful utilizing ExFi v2 as it is still a work in progress, opaque, and centralized until the official protocol launch with rebranding to Songbird Finance.