If the collateral value decreases under a specific threshold (Collateral factor), the associated debt can be made available for liquidation by the smart contract. Liquidators then pay back the debt in exchange for receiving an extra 10% of the borrower's collateral(Liquidation incentive). Debt can also be rescued by “topping up” the collateral, such that the loan is sufficiently collateralized and then, the borrower can repay parts of their debt.
Fountain Protocol has the following liquidation parameters:
Close Factor set to 50%, means the liquidator can only pay up to 50% of the debt in a single liquidate transaction.
Liquidation Incentive set to 10%, means the liquidator will receive an extra 10% of the borrower's collateral for liquidate transaction.
Concretely, if a user borrows 1000 USD worth of loan, he/she needs to put in more than 1000 USD worth of collateral, exactly how much more the user needs to put in depends on the type of collateral. Generally, if the collateral is more volatile, users will need additional collateral. If the collateral is in stable coins, users will need less collateral.
For instance, if a user wants to borrow 1200 USD worth of ETH with USDC. Using the current LTV ratio of USDC (60%), users need to put in 1200 / 0.60 = 2000 USD worth of USDC.
Say ETH is worth 4000 USD and the user borrows 0.3 ETH with his collateral. In the event whereby ETH increases in value and is now worth 4200 USD, the original 0.3 ETH is worth 1260 USD which makes the original collateral of 1200 USD insufficient, Liquidation occurs.
At this point, the liquidator can come in and liquidate this particular loan by repaying on behalf of the user, and in return get back the collateral with bonuses. If the liquidator doesn’t come in and the price of ETH keeps increasing, the value of the collateral will not be enough to cover the loan which causes lenders not to be able to recover their original deposit of 0.3 ETH. Liquidation helps prevent the loss of the lender and is in itself a profitable endeavor due to the additional bonus.