A liquidation mechanism is the set of protocol rules and procedures used to reduce or close an undercollateralized stablecoin position when its collateral ratio falls below a defined threshold.
Liquidation systems can sell collateral through auctions, automated market transactions, direct purchases by liquidators, or other protocol-defined processes. The mechanism usually repays or cancels outstanding stablecoin debt and can impose penalties on the collateral owner. Its performance depends on reliable price data, liquid markets, adequate incentives for liquidators, and the ability to process transactions during periods of congestion or rapid price declines.
The liquidation mechanism is the rule set and process. Collateral liquidation is the actual sale or transfer of collateral under that mechanism.
A weak liquidation process can leave a protocol with bad debt when collateral prices fall faster than positions can be closed.
A protocol may authorize liquidators to purchase discounted collateral once a vault falls below its minimum collateral ratio.