can someone explain liquidations to me -for the case when price of borrowed asset suddenly goes up and in turn exceeds the supplied collateral value?

Question

I understand concept of liquidations, which is when the value of collateral drops below the borrowed asset value - this can happen either when :

• collateral asset value drops

• borrowed asset value suddenly goes up

what does not make sense intuitively is the 2nd case when a borrowed asset value goes up .

For example, if i take a loan of $100 BAT when BAT is $1 a coin, and if BAT goes up $2, isn't it a good thing since my BAT is now worth $200 and i can still can service the loan plus have extra profits to pocket? Why do i get liquidated when the borrowed asset value goes up (which causes ratio of supplied collateral to borrowed value to dip below 1)

Answer 1

Lets imagine the borrowing and lending scenarios with Bob and Alice. Alice borrows some 100 BAT valued at $1 each and puts up 0.1 ETH as collateral which is valued at $200 (since ETH is $2000). Bob provides the 100 BAT here and everything is managed by the smart contract.

Alice now has the 100 BAT and can literally decide to run away with this amount, the only thing stopping her is the collateral of 0.1 ETH which is worth more. Hence it is in Alice's interest to pay back the 100 BAT and get the ETH back. Unless one of two scenarios happen.

• First, the price of ETH may depreciate and be worth less than $100, in this case Alice would not want give the 100 BAT back since she can buy more ETH on the market with her BAT. It is important that the smart contract liquidates Alice before this happens so that BOB is not left with a less valuable asset.
• Second, the price of BAT appreciates, lets say to $2.5. Now the 100 BATs are worth more than 0.1 ETH, if you were Alice would you give back the BATs for the ETH given that you'll be giving up your $250 in the wallet for $200. Hence the smart contract needs to liquidate before this scenario happens.

In general, the value of borrowed assets must always be less than the value of the collateral, otherwise there is no incentive for the borrower to pay it back.