REMINDER: Just Because You CAN Have a 110% Collateral Ratio, Doesn't Mean You SHOULD!

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By Connor
Estimated reading: 6mins
Optimal collateral ratio

The collateral ratio you set when opening your vault on Liquid Loans could have a drastic impact on your Liquid Loans experience.

Here's how to avoid getting liquidated by finding the sweet spot between capital efficiency and safety. 

What is a Collateral Ratio? 

In the context of Liquid Loans, the collateral ratio is the ratio between the US Dollar value of the PulseChain (PLS) in your vault and its debt in USDL.

The minimum amount of collateral that you can have in your Vault at any point in time is 110%. If your individual collateral ratio dips below that, your Vault will be liquidated.

For example, if you took out $2,000 USDL from the network on a timeless repayment schedule, you would need to put a minimum of 2,200 USD worth of PLS (110% of your debt) into your Vault as collateral. 

Having this minimum collateral ratio allows the Liquid Loans to always stay overcollateralized. This is why Liquid Loans is immune to bank runs, which have taken down many major banks and exchanges.

At any given point in time, there is always more PLS than USDL in the ecosystem. This means that even if every user wanted to liquidate their Vault at the exact same time and withdraw their PLS, the network would be able to comfortably meet this demand.

With Liquid Loans, you are free to set the collateral ratio of your Vault based on your own needs.

110% — for those who are okay with risk

The minimum amount of collateral that someone can use to open a vault is 110%. This is known as the minimum collateral ratio (MCR).

However, even though you can open a Vault with a 110% collateral, it typically isn’t a good idea.

While 110% might seem like the right choice from the perspective of trying to be as capital efficient as possible, it could actually make you lose money over time.

If the collateral ratio of your Vault reaches any lower than 110%, anyone will be able to liquidate your Vault. People are highly incentivized to do so, as liquidating a Vault means receiving a compensation of 200 USDL + 0.5% of the Vault’s collateral.

This means that when you open a Vault with a collateral ratio of 110%, you have virtually no buffer from price fluctuations or the ecosystem entering recovery mode.

In other words, having this low of a collateral ratio means that your vault is likely to get liquidated. 

150% — for those who keep their eye on the ball

With a collateral ratio of 150%, you have more protection from being liquidated than if you used the minimum collateral ratio of 110%.

This collateral ratio is also sufficient to keep your Vault safe during recovery mode.

However, with this ratio, you will likely need to keep a constant eye on developments in the PulseChain (PLS) market.  

By keeping a close eye, you might be able to act fast enough to avoid your vault being liquidated at times when the price of PLS fluctuates. In that scenario, you could add collateral and/or repay debt to increase your collateral ratio when your vault is at risk of being liquidated.

While that might be an ideal option for some as it is incredibly capital efficient, keeping a close eye on the market can be a demanding process. In addition, it does not offer the same level of protection as higher collateral ratios. 

250% — for those with a daily focus 

With a 250% collateral ratio, you have a significant buffer that can help prevent your Vault from liquidation. 

Rather than having to keep a close eye on PLS price developments from one hour to the next, a 250% ratio could be better suited for those who only want to check in once a day. 

This means that 250% could be an ideal collateral ratio for people who want to keep their Vault safe from liquidation. While not as capital efficient as a lower ratio, such as 150%, the tradeoff of having peace of mind might make this the ideal option for some users.

500% — safe, but not capital efficient

At 500%, your odds of being liquidated are next to none.

In order to be liquidated with a collateral ratio this high, the world would have to essentially conspire against you.

However, taking out a loan with a collateral ratio of 500% is hardly capital efficient. 

This means that 500% could be an option for the most cautious users, but would not be ideal for everyone.

That’s why setting the right collateral ratio for your Vault will largely depend on your personal needs and preferences.

How Bad is a Liquidation?

Importantly, getting liquidated is not the end of the world.

When you get liquidated, your Vault will be closed. This means that you will lose your gas reserve and all the PLS in your Vault and the gas reserve, as it will be used to compensate other users in the network.

However, you will keep all of your borrowed USDL.

This means that getting liquidated results in losing a portion of your collatera’s dollar value. 

What Collateral Ratio is Right for Me?

The perfect collateral ratio for your needs will depend on how you actually intend to use Liquid Loans. 

If you are okay with the risk of your Vault being liquidated and are focused purely on capital efficiency, one of the lower-end examples on this list might actually be the right choice for you.

On the other hand, for people who are more risk averse and are willing to track price changes in the market, one of the mid-tier ratios on this list could be a great middle ground between capital efficiency and safety.

Meanwhile, for people who value the safety of their Vault above all else, higher-end ratios might be the right choice. 

Of course, you also have the option of setting a collateral ratio that falls between any of the examples on this list. You can also adjust your collateral ratio over time, by paying off a portion of your debt or by adding to your collateral.

As a truly decentralized ecosystem, the beauty of Liquid Loans is that it puts your financial future in your hands. This means that you are free to make the decisions that are best for your personal needs.

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Disclaimer:Please note that nothing on this website constitutes financial advice. Whilst every effort has been made to ensure that the information provided on this website is accurate, individuals must not rely on this information to make a financial or investment decision. Before making any decision, we strongly recommend you consult a qualified professional who should take into account your specific investment objectives, financial situation and individual needs.

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Connor is a US-based digital marketer and writer. He has a diverse military and academic background, but developed a passion over the years for blockchain and DeFi because of their potential to provide censorship resistance and financial freedom. Connor is dedicated to educating and inspiring others in the space, and is an active member and investor in the Ethereum, Hex, and PulseChain communities.

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