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While CeFi firms got greedy, overleveraged, rehypothecated funds, and doled out under-collateralized loans, DeFi performed precisely as coded without issue with full transparency. Kinda the whole point, right?    To understand why/how DeFi was able to withstand such immense selling, let’s review MakerDAO, its over-collateralized vaults, and its liquidation mechanism.    In order to take out a loan or “vault” within the Maker system, users must deposit any of the several accepted crypto-tokens into the Maker vault and then are able to borrow Dai against the value of those tokens. Typically, the collateral must be at least 150% of the value of the loan. The protocol then charges borrowers a stability fee for borrowing Dai. This fee is variable and subject to the discretion of Maker governance. Ultimately, the stability fees collected by all the Dai loans are used to buy MKR from the open market and then burn it. This stability fee/burning mechanism is the primary source of value accrual for MKR.  

An infographic explaining over-collateralization. (Source: eli5_defi/Twitter)  

The Maker Vaults, which backs Dai, has been in development since 2014 by the MakerDAO project and were initially called Collateralized Debt Positions (CDP). With a CDP, users deposit an asset (ETH, USDC, BAT) into a smart contract as collateral for a loan. Once in the CDP, the user can generate ~60% of the USD value in Dai they wish to borrow. Users cannot borrow 100% against their collateral due to liquidation risk and price volatility in the underlying assets. However, with the new funds they have from the loan, users can spend their Dai like any other cryptocurrency, even to buy more ETH. The originally deposited assets inside the CDP can be retrieved once the user has paid back the amount of Dai they initially borrowed plus any interest accrued during the loan.    At the beginning of the project, Dai launched with support for only one type of collateral, Pooled Ether, also known as PETH. Users first needed to deposit their ETH into a smart contract that pools together ETH and then would receive the equivalent amount in PETH. The pooling system helped mitigate downside risk in a market crash. If the ETH price crashed, the debt in a CDP would be worth more than the collateral held. Maker would then have the ability to recapitalize the market by automatically decreasing the supply of PETH, increasing demand and, in turn, increasing the price of Dai. This then increases the value of the collateral in a CDP and decreases the overall value of debt.

Liquidation is the process of selling collateral to cover the amount of Dai a user has minted from their vault when the loan-to-value (LTV) ratio crosses the predetermined threshold. It ensures that Dai is always backed by enough collateral (in USD terms) by closing out vaults under their minimum required collateralization ratio. Liquidations are triggered automatically by the protocol in which the protocol sells/auctions enough of the collateral off to service the debt plus a liquidation penalty. The protocol determines after comparing the liquidation ratio to the current collateral-to-debt ratio of a vault. Each vault type has an individual liquidation ratio, determined by MKR voters based on the risk profile of the particular collateral asset type.    In May of 2021, Maker introduced Liquidations 2.0  after deficiencies in its prior liquidation method became apparent. The liquidation is actually an auction that anyone can participate in, and bidders in these auctions are known as auction keepers. They are external actors that automate certain operations around the Ethereum blockchain for a profit incentive. Proceeds from liquidation penalties are put towards the surplus auctions, which result in burned MKR.    Since then, liquidations are not handled via a single Dutch auction. In a Dutch auction, the collateral is initially priced at a high bid that gradually decreases until a buyer buys at that price. If no buyer is present, the collateral continues to be discounted up to a predefined limit or until the auction ends.    In this scenario, potential liquidators must constantly decide whether to purchase at the current price or wait until the discount increases. If the second option is selected, the potential liquidator risks losing the asset to a competitor willing to purchase at a slightly higher rate. Thus, liquidators will choose to liquidate when the bid is profitable enough for them to accept.    Dutch auctions enable larger loans to be profitably liquidated at a reduced discount compared to smaller loans.    Consequently, the discount can scale more effectively with gas prices over that period. During periods of network congestion, a greater percentage discount will be required to conclude the auction than during network slack, all else being equal.

A summary of lending platforms by mechanism. (Source: Delphi Digital)