Liquidations

Kyan's risk engine is designed to preserve solvency and protect the protocol from losses due to user defaults. Liquidation is the last-resort mechanism used to rebalance undercollateralized portfolios and minimize losses.

Below, we break down how liquidations are triggered and executed, and how Kyan’s system manages risk throughout the process.

Why Liquidation Is Necessary

In leveraged trading, if a user’s equity falls below their margin requirements, the platform becomes exposed to losses if the user’s positions move further against them. To prevent this, Kyan initiates liquidation whenever the user's Maintenance Margin (MM) exceeds their equity value, or equivalently, when the Maintenance Margin Ratio (MMr) exceeds 100%.

At this point, the liquidation engine steps in to reduce risk and restore margin health. If unsuccessful, it proceeds to fully close the account to prevent insolvency.

Liquidations: Step by Step

When MMr > 100%, the user can no longer trade (only deposit more collateral in USDC) and Kyan begins a structured three-phase liquidation process:

Step 1: Delta Hedging or Perp Liquidation

In this step, Kyan opens additional positions to offset the portfolio's directional exposure, unless the account is perp exposure only. For those accounts, Kyan will liquidate the entire position.

Delta hedging does not require an auction. It can be done directly via the orderbook via limit orders with incentive “built into” the limit price (spot oracle + incentive). Limit prices will be adjusted frequently as spot price changes, to incentivize a quick liquidation.

In most cases, this is sufficient to bring the portfolio back to a safe range without further action. Delta hedging is cheap, fast, and minimally disruptive to the user's positions.

Step 2: Portfolio Decomposition

If delta hedging is not enough, Kyan decomposes the portfolio into simpler, liquidatable components. In this phase, the risk engine defines the risk of the individual legs and ranks the positions from largest risk to smallest risk.

Note: This step is only used for portfolios with options.

1. Synthetics Synthetics are a combination of a call and a put that are at the same strike/expiration: one long, the other short. This represents the equivalent of a long/short position in the underlying asset, which is why it's called a "synthetic". They are unwound using two limit orders. Perps are used in conjunction with synthetics to hedge them, which minimizes the exposure to extremely low risk. The only exception where a synthetic is likely to be liquidated is if the account has entered into bankruptcy state in which the account will be fully closed of all positions.
2. Vertical Spreads Vertical spreads (e.g., long one call, short another) are decomposed and offset via two-sided orders to unwind the capped exposure.
3. Peripherals Peripheral option exposures are positions that do not have any strong relationship with the other options in the portfolio. These positions are meant to be treated individually during the liquidation process.

Once positions are broken up into peripherals, spreads and synthetics, each exposure is ranked by its margin requirement in isolation. Positions that have the largest margin requirement are executed first.

Step 3: Full Liquidation & Bankruptcy

If the portfolio still cannot be stabilized, the system begins full liquidation:

1. Positions are auctioned off at fair value, with a liquidation incentive added to attract counterparties.
2. If no takers appear, the incentive increases incrementally (every 1 minute for options, every 10 seconds for perps) until someone accepts the trade.
3. If still no one takes the positions, the account is flagged as bankrupt, and the insurance fund steps in to absorb the loss.