Summary

Part 1: Full liquidation cannot occur when collateral ratio is below 110% since the protocol takes a 10% flat fee for every liquidation. It is known that the protocol allows bad debt and thought about insolvency, but from a collateral ratio of 101-109%,liquidators should still be able to conduct full liquidation.

Part 2: Even if the liquidator decides to partially liquidate the position with a collateral ratio of 101-109%, it may cause a liquidation crisis.

Vulnerability Details

Part 1:

Here is the liquidation part

Whenever a liquidator decides to liquidate a position that is underwater (below 200% collaterization rate), he earns a flat fee of 10%. For example, if the collateral is worth $10,000 and the minted DSC amount is $6,000, the collateral ratio is 166%, and the position is subjected to liquidation. The liquidator repays back $6,000 DSC tokens and is eligible to claim $6,600 worth of collateral. This incentivizes the liquidators to do their job and make the protocol healthy. The protocol also notes that bad debt exists.

However, in the ranges of 101-109% collaterization rate, the liquidators is unable to conduct a full collaterization because there is not enough balance in the position to payback the liquidator. The problem lies in _redeemCollateral()

For example, if the collateral amount of a position is $10,000 and the DSC amount is $9,500, collaterization ratio is 105%. Ideally, the liquidator is still incentivized to liquidate as there is still $500 to earn. However, liquidation will fail because s_collateralDeposited[from][tokenCollateralAddress] -= amountCollateral; will result in underflow. The users only have $10,000 as collateral but $10,450 is being subtracted ($9,500 and 10% fee). This means that the liquidator cannot profit from liquidating positions in the 101-109% collaterization ratio range.

Part 2:

Even if the liquidator decides to partially liquidate the position with a 101-109% collateral ratio, a liquidation crisis may occur. For example, taking the values of the above paragraphs (Collateral = $10,000, DSC amount = $9,500, Collateralization Ratio = 105.26%). The liquidator knows that he cannot pay back the full $9,500 amount, so he decides to pay back $5,000 worth of DSC and get back $5,500 worth of collateral back. The new amount becomes (Collateral = $4,500, DSC amount = $4,500, Collaterization Ratio = 100%)

The Collaterization ratio drops from 105.26% to 100%, which means that the position is worse off than before. After liquidating a position, the position should be healthier, and not worse off than before. This is the liquidation crisis that will occur when liquidating between the ranges of 101-109% collaterization ratio. The liquidator can repeat this step to until it is no longer profitable for the liquidator leading the protocol to accumulate bad debt.

Impact

1. Full liquidation cannot happen below 110% collaterization ratio

2. Liquidation crisis will occur when liquidating a position below 110% collaterization rate.

Tools Used

Manual Review

Recommendations

The problem lies in the fix 10% reward given to the liquidator. When a position has a collateral ratio below 110%, the reward percentage should be adjusted accordingly instead of a giving the liquidators a fixed reward of 10%.