The Loss Waterfall
Every kind of loss has a fixed order of who absorbs it, and Senior always comes last. Other borrowers never pay for someone else's liquidation.
Who absorbs what
| Loss | Who absorbs it, in order |
|---|---|
| Bad debt after a liquidation | Insurance Fund, then Junior, then Senior |
| Cost of closing calls during a liquidation | The liquidated borrower's penalty, then the Insurance Fund, then Junior, then Senior |
| A cycle that settles below what was accrued | Junior, then Senior, spread over the following 7 days |
| A contract that settles below zero | Spout. Lenders receive zero for that contract, not a negative amount |
Example 1: a small bad debt
A pool holds $10m: $8.5m Senior and $1.5m Junior. The Insurance Fund holds $150,000. A gap down leaves $100,000 of bad debt. The Insurance Fund pays all of it. Lenders are untouched.
Example 2: a large bad debt
Same pool, but the Insurance Fund holds $200,000 and the bad debt is $500,000.
- The Insurance Fund pays $200,000 and is empty.
- Junior absorbs the remaining $300,000, 20% of its $1.5m. Junior's share price falls 20%.
- Senior is untouched.
For a loss to reach Senior here, it would need to use up the Insurance Fund and all $1.5m of Junior first.
After a loss
The Insurance Fund refills from half of every protocol fee and from liquidation penalties. While it is below its target, the protocol fee stays at 20%, so it refills faster.