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Liquidity pool holds token X. User decides to short token X. Pool collects collateral from user, then market sells token X. User can buy token X back and return to pool at any time. If not returned and liquidation threshold reached, off-chain bot triggers liquidation for a % reward.

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So it runs a liquidity pool that plays the role of the hypothecation agreement in stock trading?

Correct. The liquidity pool is a smart contract that accepts collateral + trade and stores liquidation threshold. If collateral ratio falls, a bot can trigger liquidation by calling smart contract, smart contract verifies that threshold has been breached, and if so will liquidate collateral to buy back asset.

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