Liquidation

Liquidation ensures protocol solvency by allowing third-party keepers (or anyone) to intervene when a user's equity falls below the maintenance margin. This prevents bad debt from cascading during market volatility.

Liquidation Trigger

A user becomes liquidatable when:

\text{Portfolio Equity} < \text{Maintenance Margin}

Important: Both longs AND shorts can be liquidated if their equity falls below maintenance margin. The key difference is in their risk profiles:

Position Type	Max Settlement Loss	Margin Basis	Can Be Liquidated?
Option Long + Premium Payer	Premium Payer obligation (bounded, deterministic)	Option stress loss + Notional Buffer	Yes
Option Short + Premium Receiver	Stressed intrinsic - Premium receivable	Stressed option loss + Notional Buffer	Yes
Mixed portfolios	Combined exposure	Portfolio stress loss + Notional Buffer	Yes

Note: In the Four-Instrument Model, option positions and premium positions are separate instruments. A typical buyer holds both an Option Long AND a Premium Payer position. The premium obligation comes from the Premium Payer instrument, not from the Option Long.

See Margin System: Long Only for detailed margin calculations.

The Liquidation Process

Trigger: Keeper detects Equity < MM
Calculate: Determine debt and positions to close
Transfer Positions at penalized mark price:
- Long positions: Liquidator pays user at mark × (1 - penalty%) and receives the optionBalance
- Short positions: User pays liquidator at mark × (1 + penalty%) for taking the obligation
Pay Bounty: Liquidator receives 5% of debt (from user's collateral first, insurance covers any shortfall)
Cover Remaining Debt: If user still has negative equity after transfers, insurance fund covers

Important: Only the optionBalance transfers to the liquidator. The user's premiumBalance (premium obligations) remains with the user and settles at expiry. Liquidators must have deposited collateral (USDC) to pay for acquiring long positions.

Position Transfer Cash Flows

Liquidation uses a position transfer model — the liquidator acquires positions rather than closing them on the market. This creates bidirectional USDC flows through the vault:

┌─────────────────────────────────────────────────────────────────────┐
│           LONG POSITIONS: Liquidator buys at discount               │
├─────────────────────────────────────────────────────────────────────┤
│                                                                     │
│  Liquidator ────USDC (mark × (1 - penalty%))────► User (liquidated) │
│       │                                                │            │
│       │  Receives position                             │            │
│       │  (at discount)                     Receives cash            │
│       ▼                                    (loses position)         │
│                                                                     │
└─────────────────────────────────────────────────────────────────────┘

┌─────────────────────────────────────────────────────────────────────┐
│       SHORT POSITIONS: Liquidator takes obligation for payment      │
├─────────────────────────────────────────────────────────────────────┤
│                                                                     │
│  User (liquidated) ────USDC (mark × (1 + penalty%))────► Liquidator │
│       │                                                     │       │
│       │  Pays to transfer                       Receives cash       │
│       │  short obligation                       + takes obligation  │
│       ▼                                                             │
│                                                                     │
└─────────────────────────────────────────────────────────────────────┘

┌─────────────────────────────────────────────────────────────────────┐
│                    BOUNTY + SHORTFALL COVERAGE                      │
├─────────────────────────────────────────────────────────────────────┤
│                                                                     │
│  1. Bounty (5% of debt): User ────────────────► Liquidator          │
│     If user cannot cover: Insurance Fund ─────► Liquidator          │
│                                                                     │
│  2. Bad Debt: If user equity still negative after transfers         │
│     Insurance Fund covers remaining shortfall                       │
│                                                                     │
└─────────────────────────────────────────────────────────────────────┘

Cash Flow Summary

Step	Direction	Amount	Purpose
1. Longs	Liquidator → User	`longsCost`	Pay for long positions (optionBalance)
2. Shorts	User → Liquidator	`shortsCost`	Transfer short obligations (optionBalance)
3. Bounty	User → Liquidator	5% × debt	Incentive payment
4. Bounty shortfall	Insurance → Liquidator	remainder	Guarantee bounty
5. Bad debt	Insurance → Protocol	as needed	Cover negative equity

See DiffusalLiquidationEngine for implementation details.

Debt Calculation

\text{Debt} = \text{Initial Margin} - \text{Portfolio Equity}

If Debt > 0 and Equity < MM, the user is underwater and liquidation is triggered.

Mark Price Liquidation

Liquidations use the mark price (Black-Scholes theoretical) directly. They do not go through the orderbook or RFQ system.

The liquidator buys positions directly from the liquidated user at a penalized mark price:

Position Type	Liquidation Price	Effect
Long (size > 0)	mark × (1 - penalty%)	Liquidator buys at discount
Short (size < 0)	mark × (1 + penalty%)	Liquidator buys back at premium

The liquidator immediately earns the penalty as profit. They can then sell the acquired positions via orderbook or RFQ.

Volatility-Adjusted Penalty

The liquidation penalty scales with implied volatility to properly incentivize liquidators during market stress:

\text{Penalty Rate} = \text{Base (1\%)} + \frac{\text{Current IV} - 50\%}{100}

Examples

IV	Penalty Calculation	Rate
50%	1% + (50-50)/100	1.0%
75%	1% + (75-50)/100	1.25%
100%	1% + (100-50)/100	1.5%
150%	1% + (150-50)/100	2.0%

Penalty Rate Bounds

Parameter	Value	Description
Minimum	1.0%	Base rate (when IV ≤ 50%)
At baseline	1.0%	When IV = 50%
Maximum	100%	Capped to ensure liquidators don't pay more than position value

Note: The penalty rate is capped at 100% to ensure liquidations remain viable even in extreme IV conditions. In extreme IV environments, liquidators need large discounts to take on risk, but above 100% would mean paying more than the position's value, which would never be profitable.

Why Volatility Adjustment Matters

In high volatility environments:

Positions move faster - A barely underwater position can become deeply underwater within blocks
Liquidators take more risk - Prices may move against them before they can hedge
Higher penalties compensate - Ensures liquidators remain incentivized during stress

Without vol-adjustment, liquidators might delay during market stress (when liquidations are most critical), leading to bad debt accumulation.

Partial vs Full Liquidation

The protocol supports partial liquidation to give users a chance to recover.

Key Insight

Margin requirements use stressed scenarios (±30% spot, +50% IV), but liquidation executes at current mark prices. This means:

Selling positions at current mark barely reduces equity (just the penalty)
But it dramatically reduces the margin requirement (which was stress-based)
So partial liquidation often restores health without destroying the user

The Asymmetry That Enables Partial Liquidation

The margin system uses stressed prices for requirements, but liquidation uses current prices:

Option	Current Mark	Stressed (Scenario 1)	Difference
ETH Call ($3,200 strike)	$116.25	$4.73	-$111.52
ETH Put ($2,800 strike)	$92.00	$709.69	+$617.69

Why this matters:

Margin requirement uses $710 put value → requires ~$7,100 collateral per 10 short puts
Liquidation uses $92 put value → transfer costs only ~$920 per 10 short puts
This $618 spread per contract is why closing 50% of positions often restores health

The stress scenarios assume extreme market moves that may never happen. When liquidation executes at current prices, the actual cost is much lower than what the margin system reserved for.

Position Selection: Longest-Dated First

The protocol liquidates positions starting with the longest-dated positions first. This ordering:

Prioritizes positions furthest from expiry (most liquid, easiest for liquidators to hedge)
Preserves near-expiry positions that may settle soon
Ensures predictable liquidation behavior

Notional-Based Partial Liquidation

Partial liquidation calculates how much notional value to liquidate based on the debt-to-margin ratio:

\text{Total Notional} = \sum_i \text{mark}_i \times |\text{optionBalance}_i|

\text{Target Notional} = \text{Total Notional} \times \frac{\text{Debt}}{\text{Initial Margin}}

The protocol supports partial position liquidation — a single position can be partially liquidated to hit the exact target notional. This is more capital-efficient than rounding up to whole positions.

Liquidation Process

Trigger: Equity < MM
Sort: Order all positions by expiry descending (longest-dated first)
First Attempt: Liquidate positions until target notional is reached, starting from longest-dated. Supports partial liquidation within a single position.
Re-check: Is user now healthy? (Equity ≥ MM)?
- If yes, stop and user retains remaining positions
- If no, automatically escalate to full liquidation (close remaining positions)

Why Longest-Dated First?

Liquidity: Longer-dated options typically have better liquidity for liquidators to exit
Preservation: Near-expiry positions may settle naturally, avoiding forced liquidation costs
Predictability: Clear ordering removes ambiguity about which positions get closed

After liquidation, the user retains any remaining equity and positions (if partial was sufficient).

Liquidator Incentives

Liquidators are compensated through two mechanisms:

1. Penalty Profit (1-2%+)

Liquidators acquire positions at a discount/premium from mark price:

Long positions: Liquidator pays at mark × (1 - penalty%), immediately gaining the penalty as profit. For example, with mark price $100 and penalty 1.5%, the liquidator pays $98.50 for a position worth $100.

Short positions: User pays liquidator at mark × (1 + penalty%) to take the obligation. The liquidator is compensated for assuming the risk.

2. Bounty (5% of debt)

\text{Bounty} = \text{Debt} \times 5\%

The bounty is always paid to incentivize liquidators:

First drawn from user's collateral (after position transfers)
Any shortfall is covered by the insurance fund

This ensures liquidators are compensated even when liquidating deeply underwater users.

Bounty Scenarios

Scenario	Debt	Bounty (5%)	User Remaining	Insurance Pays	Liquidator Gets
Healthy surplus	$5,000	$250	$3,000	$0	$250
Tight margin	$5,000	$250	$200	$50	$250
Deep underwater	$10,000	$500	$0	$500	$500
Extreme deficit	$20,000	$1,000	-$5,000	$1,000 + bad debt	$1,000

Key: Liquidators always receive the full bounty. The insurance fund guarantees this regardless of how underwater the user is.

Total Liquidator Profit

\text{Total Profit} = \text{Penalty Profit} + \text{Bounty}

This incentivizes keepers to monitor positions and liquidate promptly, especially during high volatility when the penalty (and thus profit) is higher.

Liquidator Requirements

Liquidators must have deposited collateral to participate:

For long positions: Liquidator needs USDC to pay for the positions
For short positions: No upfront payment needed (user pays liquidator)
Liquidator must remain healthy (equity ≥ MM) after acquiring positions

If the liquidator would become unhealthy after acquiring positions, the transaction reverts with LiquidatorUnhealthy().

Liquidator Health Check Example

Scenario: A liquidator with insufficient collateral attempts to acquire positions.

Liquidated user's positions:

Long 10 ETH Call ($3,200 strike, 90d) — mark $296.23
Short 5 ETH Put ($2,800 strike, 60d) — mark $165.58

Liquidator state:

Item	Before	After Acquisition
Deposit	$10,000	$10,000 - $2,932.68 (paid for longs) + $836.18 (received for shorts) = $7,903.50
Positions	None	+10 long calls, -5 short puts
Option Value	$0	($296.23 × 10) + ($165.58 × -5) = $2,134.40
Premium Balance	$0	$0 (liquidator doesn't inherit user's premium)
Equity	$10,000	$7,903.50 + $2,134.40 + $0 = $10,037.90
New IM	$0	$9,418.41
New MM	$0	$7,534.73

Health check: $10,037.90 > $7,534.73 → HEALTHY ✓

When liquidation fails: If the liquidator had less initial deposit (e.g., $5,000), they might still become unhealthy after paying for longs and taking on the margin requirements for the short positions.

Solutions for an undercollateralized liquidator:

Deposit more collateral before attempting liquidation
Target smaller positions that won't exceed their margin capacity
Have existing offsetting positions that reduce the combined IM

Post-Liquidation

After acquiring positions, the liquidator can:

Action	Description
Sell via limit orders	Place orders on the orderbook
Sell via RFQ	Request quote from Main Market Maker
Hold positions	Keep exposure if desired
Hedge externally	Offset risk on other venues

Insurance Fund

The insurance fund provides two types of coverage:

1. Bounty Guarantee

The 5% bounty is always paid to liquidators to ensure incentives remain strong:

First drawn from user's collateral (after position transfers)
Insurance fund covers any bounty shortfall

2. Bad Debt Coverage

When the user still has negative equity after all transfers:

\text{Shortfall} = -\text{User Equity (after transfers)}

The Insurance Fund covers any remaining bad debt.

DiffusalInsuranceFund Contract

The insurance fund is a separate contract (DiffusalInsuranceFund) that:

Receives all protocol trading fees (set as feeRecipient on OrderBook and RFQ)
Holds funds in a deposit on the CollateralVault
Provides cover() function callable by LiquidationEngine or SettlementEngine

Insurance Fund Sources

Source	Description
Protocol fees	All trading fees routed via `feeRecipient`
Initial seed capital	Bootstrap funding via deposits

Flow Diagram

At settlement, funds flow from short holders (obligations) to the settlement pool, then to long holders (payouts). If there's a shortfall, the insurance fund provides coverage.

Settlement Waterfall (Order of Operations)

When liquidation completes, cash flows settle in this exact order:

Step	Action	From	To	Condition
1	Long position payment	Liquidator	User	Always (for each long)
2	Short obligation transfer	User	Liquidator	Always (for each short)
3	Net position settlement	—	—	Aggregate steps 1-2
4	Bounty payment	User deposit	Liquidator	Up to available balance
5	Bounty shortfall	Insurance Fund	Liquidator	If step 4 insufficient
6	Bad debt coverage	Insurance Fund	Protocol	If user equity negative

Example (deeply underwater user):

Initial state:
- Debt: $20,000
- Bounty owed: $1,000 (5% of debt)
- User deposit remaining after transfers: $500

Settlement order:
1. Steps 1-3: Position transfers complete (net: user has $500 remaining)
2. Step 4: User pays $500 bounty (all available)
3. Step 5: Insurance covers $500 bounty shortfall
4. Step 6: Insurance covers any remaining bad debt

Result: Liquidator receives full $1,000 bounty (guaranteed)

Settlement Readiness Liquidation

There's a subtle risk in options trading: a user can have high portfolio equity from profitable long positions but minimal actual cash (USDC deposits). When their positions expire, they need actual cash to pay settlement obligations, but their "paper profits" from longs aren't liquid.

The Problem (Deferred Settlement Model)

With the fungible options model and deferred settlement, positions can have settlement obligations:

Net Settlement Formula:

\text{netSettlement} = (\text{intrinsic} \times \text{optionBalance}) + \text{premiumBalance}

Where:

optionBalance: Signed position size (+ = long, - = short)
premiumBalance: Signed premium position (+ = receivable, - = payable)

Settlement obligations arise when netSettlement is negative:

Option Shorts: Pay intrinsic obligation (offset by any Premium Receiver balance they hold)
Premium Payers: Pay their fixed premium obligation (separate from option position)

Consider this scenario:

Item	Value
Deposited collateral	$2,000
Long-dated calls value	+$50,000 (paper)
Short puts expiring tomorrow (Option Short)	-$8,000 (worst-case intrinsic obligation)
Premium Payer balance for expiring calls	-$2,000 (fixed premium obligation)
Portfolio Equity	$40,000

The user looks healthy (equity >> MM), so they can't be liquidated. But at settlement tomorrow:

Cash needed: $10,000 (short intrinsic + premium payer obligation)
Cash available: $2,000
Result: Settlement failure

Solution: Pre-Settlement Liquidation

Settlement Readiness Liquidation is handled by a separate contract (DiffusalSettlementReadinessLiquidator) that liquidates non-expiring LONG option positions to raise cash when positions are approaching settlement and the user lacks sufficient cash. This is a separate liquidation type from margin-based liquidation.

Key difference from regular liquidation:

Regular liquidation: Restores margin health by transferring both longs AND shorts

Settlement readiness: Raises cash by selling longs and premium receivables (shorts are obligations, not extractable value)

What can be liquidated:

Non-expiring LONG option positions (optionBalance > 0) — positive mark value that can be sold for cash
Premium receivables (positive premiumBalance) — deterministic value, liquidated at a discount

What CANNOT be liquidated:

Option shorts — they represent obligations, not extractable value
Premium payables — they are obligations that settle at expiry

Trigger conditions (all must be true):

User has positions expiring within 1 day with net obligations
User's deposited collateral (cash) is insufficient to cover worst-case obligations
User has valuable non-expiring LONG option positions that can be liquidated
User is not an MMM (Main Market Maker)

How It Works

Calculate Cash Shortfall
- Identify expiring positions within SETTLEMENT_READINESS_WINDOW (1 day)
- Calculate worst-case obligations:
  - Option shorts: stressed intrinsic × |optionBalance| (if ITM under stress)
  - Premium payers: |premiumBalance| (fixed, deterministic)
- Net shortfall = total obligations - deposited cash
Liquidation Waterfall (in order)

Step 1: Non-Expiring Long Option Positions
- Long option positions (optionBalance > 0) sorted by expiry (longest-dated first)
- Liquidator pays penalized mark price, receives the option position
- Stop when shortfall is covered (or all liquidatable assets exhausted)
Step 2: Premium Receivables (at discount)
- If shortfall remains and user has premium receivables (positive premiumBalance)
- Liquidated at a discount rate (default 5%, max 20%)
- Value realized = premiumReceivable × (1 - discountRate)
- Premium position transfers to liquidator
Position Transfer
- User receives cash from liquidator (penalized mark price for options, discounted value for premiums)
- Liquidator acquires the long option position and/or premium receivable
- Premium payables are NOT transferred — they remain with original holder

Worst-Case Obligation Calculation (Net Settlement Model)

The protocol calculates obligations using SPAN stress scenarios with the netSettlement formula:

\text{netSettlement} = (\text{intrinsic}_{\text{stressed}} \times \text{optionBalance}) + \text{premiumBalance}

\text{Obligation} = \max(0, -\text{netSettlement})

For Expiring SHORT Positions

Shorts have obligations when stressed intrinsic payout exceeds their premium receivable.

Option Type	Worst-Case Scenario	Stressed Spot	Why
Short Call	Spot rises +30%	spot × 1.3	Maximizes intrinsic
Short Put	Spot drops -30%	spot × 0.7	Maximizes intrinsic

Example (Short 5 puts, premiumBalance = +$600):

\text{Intrinsic}_{\text{stressed}} = \max(0, \text{Strike} - \text{Spot} \times 0.7) = \$700

\text{netSettlement} = (\$700 \times -5) + \$600 = -\$3{,}500 + \$600 = -\$2{,}900

\text{Obligation} = \max(0, \$2{,}900) = \$2{,}900

Key insight: The premium already received ($600) reduces the obligation from $3,500 to $2,900.

For Positions with Premium Payer Balances

Users with Premium Payer positions (premiumBalance < 0) have obligations equal to the premium they owe. For users who also hold expiring Option Long positions, the intrinsic payout from the long offsets the premium obligation.

Note the opposite stress direction for calculating worst-case - we minimize intrinsic to find the maximum net obligation:

Option Type	Worst-Case Scenario	Stressed Spot	Why
Long Call	Spot drops -30%	spot × 0.7	Minimizes intrinsic payout
Long Put	Spot rises +30%	spot × 1.3	Minimizes intrinsic payout

Example (Long 10 calls + Premium Payer -$1,500):

\text{Intrinsic}_{\text{stressed}} = \max(0, \text{Spot} \times 0.7 - \text{Strike}) = \$0 \text{ (OTM)}

\text{netSettlement} = (\$0 \times 10) + (-\$1{,}500) = -\$1{,}500

\text{Obligation} = \max(0, \$1{,}500) = \$1{,}500

Key insight: The Premium Payer obligation is bounded and deterministic (fixed at trade time). The Option Long position has no obligation—it only receives intrinsic (or nothing if OTM). The net settlement combines both instruments.

Liquidation Waterfall Diagram

SETTLEMENT READINESS LIQUIDATION WATERFALL
══════════════════════════════════════════

┌─────────────────────────────────────────────────────────┐
│          TRIGGER: Settlement Readiness Check            │
├─────────────────────────────────────────────────────────┤
│  1. Positions expiring within 1 day?                    │
│       │                                                 │
│       ▼                                                 │
│  2. User has net settlement obligations?                │
│       │                                                 │
│       ▼                                                 │
│  3. Deposited cash < worst-case obligations?            │
│       │                                                 │
│       ▼                                                 │
│  4. User is NOT an MMM?                                 │
└──────────────────────────┬──────────────────────────────┘
                           │ All conditions met
                           ▼
┌─────────────────────────────────────────────────────────┐
│     STEP 1: Liquidate Non-Expiring LONG Positions       │
├─────────────────────────────────────────────────────────┤
│  • Sort longs by expiry (longest-dated first)           │
│  • Liquidator pays: mark × (1 - penalty%)               │
│  • User receives cash, loses position                   │
│       │                                                 │
│       ▼                                                 │
│  Shortfall covered? ───► YES ──────────────────────┐    │
│       │                                            │    │
│       NO                                           │    │
└───────┴────────────────────────────────────────────┴────┘
        │                                            │
        ▼                                            │
┌────────────────────────────────────────────────────┼────┐
│       STEP 2: Liquidate Premium Receivables        │    │
├────────────────────────────────────────────────────┼────┤
│  • Find positions with premiumBalance > 0          │    │
│  • Liquidator pays: premium × (1 - discount%)      │    │
│  • User receives discounted cash                   │    │
│       │                                            │    │
│       ▼                                            │    │
│  Shortfall covered? ───► YES ──────────────────────┘    │
│       │                                                 │
│       ▼ (or exhausted)                                  │
└───────┴─────────────────────────────────────────────────┘
        │                   │
        └───────────────────┴────────► YES (done)
                            │
                            ▼
┌─────────────────────────────────────────────────────────┐
│                  STEP 3: Pay Bounty                     │
│     Keeper receives 5% of shortfall (capped)            │
└──────────────────────────┬──────────────────────────────┘
                           ▼
┌─────────────────────────────────────────────────────────┐
│                        RESULT                           │
├─────────────────────────────────────────────────────────┤
│  • User now has sufficient cash for settlement          │
│  • Expiring positions remain for normal settlement      │
└─────────────────────────────────────────────────────────┘

Key Constants

Constant	Value	Description
`SETTLEMENT_READINESS_WINDOW`	1 day	Window before expiry to trigger
`SETTLEMENT_READINESS_BUFFER`	5%	Buffer for settlement readiness calculations
`PREMIUM_RECEIVABLE_DISCOUNT_RATE`	5%	Default discount on premium receivables
`MAX_PREMIUM_RECEIVABLE_DISCOUNT_RATE`	20%	Maximum configurable discount rate
`STRESS_SPOT_UP`	1.3 (130%)	Spot up scenario
`STRESS_SPOT_DOWN`	0.7 (70%)	Spot down scenario

See DiffusalSettlementReadinessLiquidator for the contract API.

Mechanics

Step	Flow
1. Identify long positions	Sort non-expiring LONG positions by expiry (longest-dated first)
2. Liquidate longs first	Sale price = mark × (1 - penalty%), long option moves to liquidator
3. Check shortfall	If shortfall remains and user has premium receivables, continue
4. Identify premium receivables	Find positions with positive premiumBalance
5. Liquidate premiums	Value = premiumReceivable × (1 - discountRate), premium transfers to liquidator
6. Pay bounty	User → Liquidator (5% of shortfall, capped at proceeds)
7. Stop early	Once shortfall is covered (or all liquidatable assets exhausted)

Liquidator Incentives

Same as regular liquidation:

1. Penalty Profit

Liquidator buys at mark × (1 - penalty%)
Penalty rate uses same volatility adjustment formula

2. Bounty (5% of shortfall)

\text{Bounty} = \min(\text{Cash Shortfall} \times 5\%, \text{Cash Raised})

Worked Example: Sufficient Cash for Settlement

Setup: A user has short positions expiring within 1 day.

Option Position:

Series	Option Balance	Description
ETH Put $2,800	-5	Short 5 puts (expires tomorrow)

Premium Position:

Series	Premium Balance	Description
ETH Put $2,800	+$600	Received $120 each for 5 puts

Deposited collateral: $4,000 USDC

Calculate Worst-Case Net Settlement:

Under worst-case (spot drops 30%):

\text{Worst-case spot} = \$3{,}000 \times 0.70 = \$2{,}100

Intrinsic value of put at settlement:

\text{Intrinsic} = \max(0, \text{Strike} - \text{Spot}) = \max(0, \$2{,}800 - \$2{,}100) = \$700

Net settlement:

\text{netSettlement} = (\text{intrinsic} \times \text{optionBalance}) + \text{premiumBalance}

= (\$700 \times -5) + \$600 = -\$3{,}500 + \$600 = -\$2{,}900

Worst-case obligation:

\text{Obligation} = \max(0, -\text{netSettlement}) = \max(0, \$2{,}900) = \$2{,}900

Key insight: The premium already received ($600) reduces the worst-case obligation from $3,500 to $2,900.

Settlement Readiness Check:

\$4{,}000 > \$2{,}900 \quad \checkmark

Result: User has sufficient cash for settlement. No liquidation needed.

Worked Example: Settlement Readiness Liquidation

Setup: Same short position as above, but with insufficient cash and an additional long position.

Option Positions:

Series	Option Balance	Description
ETH Put $2,800	-5	Short 5 puts (expires tomorrow)
ETH Call $3,200	+10	Long 10 calls (expires in 60 days)

Premium Positions:

Series	Premium Balance	Description
ETH Put $2,800	+$600	Received $120 each for 5 puts
ETH Call $3,200	-$1,500	Paid $150 each for 10 calls
Total	-$900	Net premium payer

Deposited collateral: $2,000 USDC

Calculate Cash Shortfall:

Worst-case obligation for expiring puts:

\text{netSettlement}_{\text{put}} = (\$700 \times -5) + \$600 = -\$2{,}900

\text{Obligation} = \max(0, \$2{,}900) = \$2{,}900

Cash shortfall:

\text{Cash Shortfall} = \$2{,}900 - \$2{,}000 = \$900

Settlement Readiness Liquidation:

The user's portfolio equity is healthy (they have long calls with Option Value of $1,162.50), but deposited cash is insufficient to cover expiring position obligations.

The system liquidates non-expiring LONG positions to raise cash. Only longs can be liquidated because they have positive Option Value:

\text{Contracts to sell} \approx \frac{\$900}{\$116.25 \times (1 - 1\%)} \approx 7.8 \text{ calls}

After liquidation:

User's long calls: ~2.2 contracts remaining
User's cash: ~$2,900 (sufficient for settlement)
Short puts: unchanged (will settle normally with netSettlement formula)

Key insight: Only LONG positions can be liquidated for settlement readiness. Shorts are obligations that cannot be "sold" to raise cash.

Example: Complex Settlement Readiness

Initial State (using netSettlement formula):

Expiring Positions (12 hours to expiry):

Short 10 puts (Option Short + Premium Receiver): optionBalance=-10, premiumBalance=+$1,000
- Stressed intrinsic: $700, netSettlement = ($700 × -10) + $1,000 = -$6,000
- Net Obligation: $6,000 (intrinsic obligation partially offset by premium receivable)
Long 15 calls (Option Long + Premium Payer): optionBalance=+15, premiumBalance=-$4,500
- Stressed intrinsic: $100, netSettlement = ($100 × 15) + (-$4,500) = -$3,000
- Net Obligation: $3,000 (premium payer obligation exceeds intrinsic payout)
Total worst-case obligation: $9,000
Deposited collateral: $1,000
Cash shortfall: $9,000 - $1,000 = $8,000

Non-Expiring LONG Position (60 days to expiry):

Long 200 calls: optionBalance=+200, Option Value = $20,000 (mark × 200)

┌─────────────────────────────────────────────────────────────────────────┐
│                    SETTLEMENT READINESS LIQUIDATION                     │
│                       (Non-Expiring Long Example)                       │
└─────────────────────────────────────────────────────────────────────────┘

Initial State:
  User: Cash $1,000 | Obligations $9,000 | Shortfall $8,000
  Position: Long 200 calls (60 days to expiry), value $20,000

Step 1: Check Conditions
  ├─ Expiring positions within 1 day? Yes (12 hours)
  └─ Cash < Obligations? $1,000 < $9,000 ✓

Step 2: Liquidate Non-Expiring Longs
  Liquidator → Protocol: "Liquidate 200 calls"
  Liquidator → Vault: Pay $19,800 (mark × 0.99)
  Vault → User: Credit $19,800

  User: Cash $20,800 | Shortfall COVERED

Step 3: Pay Bounty
  User → Liquidator: $400 (5% of $8,000 shortfall)

Final State:
  User: Cash $20,400 | Obligations $9,000 | Ready for settlement

Liquidation (1% penalty) — Only the non-expiring LONG is liquidated:

Liquidator pays: $20,000 × 0.99 = $19,800
User receives: $19,800 (new cash balance = $20,800)
Bounty: min($8,000 × 5%, $19,800) = $400
User's final cash: $20,800 - $400 = $20,400

The user now has $20,400 to cover the $9,000 total obligation at settlement. The expiring positions (both the short puts and long calls) remain with the user for settlement.

Key Differences from Regular Liquidation

Aspect	Regular Liquidation	Settlement Readiness
Trigger	Equity < MM	Cash shortfall for expiring obligations
What's liquidated	All positions (longs AND shorts)	Non-expiring LONG positions (first) + premium receivables
Position handling	Transfer to liquidator	Waterfall: longs at penalty, then premiums at discount
Goal	Restore margin health	Raise cash for settlement obligations
Expiring positions affected	Yes (transferred)	No (remain for settlement)
Can shorts be liquidated?	Yes	No (shorts are obligations, not value)
Premium receivables	Transferred with option	Liquidated second at discount rate (5-20%) if shortfall remains
Premium payables	Transferred with option	NOT transferred (settle separately)

Worked Examples

For detailed worked examples of partial and full liquidation with step-by-step calculations, see:

Margin System: Example B - Partial Liquidation (Succeeds) — Shows how partial liquidation closes just enough positions to restore health
Margin System: Example C - Full Liquidation (Partial Fails) — Shows escalation from partial to full liquidation when health cannot be restored
Margin System: Example D - Unliquidatable Long Position — Shows how sufficient collateral guarantees a long-only portfolio cannot be liquidated

The settlement readiness liquidation examples are unique to this page and shown in the Settlement Readiness Liquidation section above.

Key takeaways from the margin system examples:

Notional-based partial liquidation closes only the target notional needed
Partial position liquidation is supported — fractional contracts can be liquidated
Longest-dated first ordering is deterministic and predictable
If partial fails, the system escalates to full liquidation automatically
Users retain remaining collateral after positions are transferred

Risk Parameters

Parameter	Default	Description
`LIQUIDATION_PENALTY_BASE`	1%	Base price penalty
`LIQUIDATION_PENALTY_IV_BASELINE`	50%	IV threshold for penalty scaling
`LIQUIDATOR_BOUNTY_RATE`	5%	% of debt paid to liquidator

Note: Partial liquidation uses proportional position closure (debt/IM fraction) rather than a fixed percentage.

Main Market Maker Exception

The Main Market Maker (MMM) is a privileged, non-liquidatable entity. The liquidation function rejects any attempt to liquidate the MMM address by first checking if the user is an MMM (returning false if so) before checking equity vs maintenance margin.

Why MMM Is Exempt

The MMM's solvency is managed operationally, not by protocol rules:

Concern	Mitigation
MMM goes underwater	MMM operator monitors and rebalances externally
MMM accumulates too much risk	MMM offloads shorts via limit orders or OTC
MMM runs out of capital	MMM operator injects capital before insolvency
MMM becomes malicious	Governance can replace MMM address

This is a deliberate trust tradeoff: by trusting one well-managed entity, the protocol guarantees that RFQ always functions—so liquidators can always offload acquired positions to the MMM after executing liquidations.

Smart Contract API

The DiffusalLiquidationEngine contract implements the liquidation mechanics. Liquidation is permissioned — only approved liquidators can execute liquidation functions. This ensures trusted entities (e.g., keeper bots, protocol operators) manage liquidations while maintaining protocol solvency.

Liquidation Functions (DiffusalLiquidationEngine)

liquidatePortfolio(user, portfolioId, liquidatorPortfolioId) — Liquidates an undercollateralized user's portfolio. Requires caller to be an approved liquidator. The liquidatorPortfolioId specifies which portfolio receives the acquired positions. Tries partial liquidation first (proportional fraction based on debt/IM), then escalates to full liquidation if partial doesn't restore health. Returns a LiquidationResult containing: user, liquidator, portfolioId, debt, longsCost, shortsCost, bounty, insuranceUsed, newUserEquity, newLiquidatorEquity, positionsLiquidated, isPartial.
isApprovedLiquidator(address) — Returns true if the address is approved to execute liquidations.
setApprovedLiquidator(address, bool) — (Owner only) Approves or revokes an address for liquidation execution.

Settlement Readiness Functions (DiffusalSettlementReadinessLiquidator)

Settlement readiness liquidation is handled by a separate contract (DiffusalSettlementReadinessLiquidator), which also requires approved liquidators:

getSettlementReadinessInfo(user) — Returns: isLiquidatable, cashRequired, cashAvailable, cashShortfall, totalPremiumReceivable, premiumReceivableValueAfterDiscount, positionValueAvailable, expiringShortsCount, expiringLongsCount, liquidatablePositionsCount
isSettlementReadinessLiquidatable(user) — Returns true if user meets settlement readiness liquidation conditions (expiring positions with obligations and insufficient cash)
liquidateForSettlementReadiness(user) — Liquidates using waterfall: non-expiring LONG option positions first, then premium receivables (at discount). Requires caller to be an approved liquidator. Returns: user, liquidator, cashShortfall, cashRaised, premiumLiquidated, premiumProceeds, liquidatorCost, bounty, positionsLiquidated, newCashAvailable
isApprovedLiquidator(address) — Returns true if the address is approved to execute settlement readiness liquidations.
setApprovedLiquidator(address, bool) — (Owner only) Approves or revokes an address for settlement readiness liquidation execution.
getSettlementReadinessBuffer() — Returns the settlement readiness buffer (default 5%, WAD format)
getPremiumReceivableDiscountRate() — Returns the discount rate applied to premium receivables (default 5%, WAD format)
getLiquidatorBountyRate() — Returns the liquidator bounty rate (default 5%, WAD format)
calculatePenaltyRate(pairId) — Returns penalty rate in WAD based on IV

View Functions (DiffusalLiquidationEngine)

getLiquidationInfo(user) — Returns comprehensive info: isLiquidatable, portfolioId, debt (USDC 6 decimals), estimatedLongsCost, estimatedShortsCost, estimatedBounty, positionCount
calculatePortfolioDebt(user, portfolioId) — Returns debt = max(0, Initial Margin - Equity) for the specified portfolio
calculatePenaltyRate(pairId) — Returns penalty rate in WAD (e.g., 0.015e18 = 1.5%). Penalty = Base (1%) + (IV - 50%) / 100
getInsuranceFundBalance() — Returns current insurance fund balance

External Insurance Fund

The insurance fund is a separate contract (DiffusalInsuranceFund) with these functions:

getBalance() — Current fund balance (USDC, 6 decimals)
collateralVault() — CollateralVault reference
liquidationEngine() — LiquidationEngine reference
cover(shortfallAmount) — Draw funds for shortfalls (callable by LiquidationEngine or SettlementEngine)
withdraw(amount) — Withdraw excess funds (owner only)

The insurance fund receives all protocol trading fees by being set as feeRecipient on OrderBook and RFQ contracts.

Deployment Integration

The liquidation engine must be registered as an operator on DiffusalOptionsPositionManager (for updatePosition()) and DiffusalCollateralVault (for creditCollateral() and debitCollateral()). Additionally, the insurance fund must be connected to the liquidation engine, and fees should be routed to the insurance fund.

Contract Implementation

Contract	Role
DiffusalLiquidationEngine	Core margin-based liquidation logic
DiffusalSettlementReadinessLiquidator	Settlement readiness liquidation
DiffusalInsuranceFund	Shortfall coverage
DiffusalCollateralVault	Collateral settlement

Protocol Documentation

Margin System — How IM and MM are calculated, liquidation triggers
Margin Calculations — Stress testing formulas, SPAN methodology
Options Settlement — What happens at expiry (why cash is needed for settlement readiness)

Contract Documentation

DiffusalLiquidationEngine — Core margin-based liquidation logic, position transfer implementation
DiffusalSettlementReadinessLiquidator — Settlement readiness liquidation (waterfall: longs → premiums)
DiffusalInsuranceFund — Shortfall coverage, bounty guarantee mechanism
DiffusalCollateralVault — transferCollateral() used for cash flows
DiffusalOptionsPositionManager — Position updates during liquidation
DiffusalSettlementEngine — Settlement execution (context for settlement readiness)

Liquidation

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