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DeFi 101: Liquidations

By Michael @ CryptoEQ | CryptoEQ | 19 Feb 2024


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Above all, many of DeFi’s critical lending and borrowing protocols are anchored by the support of liquidation systems. As noted in previous sections, liquidations occur when the value of a loan’s collateral falls below the value of the borrower’s outstanding debt, including interest. This means that the position is now under-collateralized and poses a threat to the health of the lending protocol. To prevent the accumulation of these bad undercollateralized positions, many DeFi protocols enable third party anonymous liquidators to repay the debt, allowing the liquidators to take possession of the remaining collateral.

Protocols often choose to utilize third party liquidations due to the gas cost of executing liquidation transactions. To automate this process would require a significant increase to the operating costs of the protocol, which would directly impact profitability. Not to mention, designing liquidation systems is extremely complex as it would require the protocol to devise an algorithmic way to strategically determine whether a position should be liquidated and when to formally execute the liquidation.

The timing is fundamentally crucial, because if a position’s debt value surpasses that of the collateral, liquidation becomes unprofitable for the liquidators, leaving the protocol with bad debt. This is precisely what happened to Aave during the CRV exploit.

Types of Liquidations

Instant Liquidations

Liquidations are a common element in traditional finance as well, but they work quite differently in DeFi. Because of the rapid volatility of many cryptocurrencies, liquidations within DeFi are “frequent, instantaneous, and executed by often anonymous operators” as Alberto Cuesta Cañada stated on Hacknoon.com. This is otherwise known as the concept of instant liquidations.

Unlike the traditional financial sector, where liquidation processes may involve lengthy procedures and regulatory oversight, DeFi platforms automate and expedite these operations. Here, anonymous liquidators play a pivotal role, operating without the need for conventional vetting processes. This setup underscores a fascinating balance: incentivizing liquidators to swiftly protect lenders from potential bad debt while safeguarding the ecosystem's integrity.

Instant Liquidations occur when the DeFi protocols automatically execute liquidation procedures in real-time as soon as a loan becomes undercollateralized. This is possible due to the integration of smart contracts, which enforce the terms of loans autonomously. The principle of solvency underpins the necessity for Instant Liquidations. 

For a loan to remain solvent, its collateral value must consistently outstrip the debt it secures. However, in DeFi's volatile markets, a solvent loan can quickly become insolvent. Instant Liquidations mitigate this risk by allowing for the immediate sale of collateral once it falls below a predefined loan-to-value (LTV) threshold, ensuring lenders are protected against significant losses.

While Instant Liquidations serve as a crucial risk management tool, they also introduce challenges. The primary concern is ensuring that these processes are fair and do not unduly penalize borrowers due to temporary market dips. Moreover, the reliance on anonymous liquidators raises questions about the execution of liquidations and the potential for manipulation.

To address these issues, DeFi protocols implement over-collateralization and carefully calibrated collateralization ratios. These measures provide a cushion against market volatility, ensuring that liquidators are incentivized to act promptly while also offering borrowers a degree of protection against immediate liquidation for minor infractions.

The collateralization ratio is instrumental in determining when a loan is eligible for Instant Liquidation. By setting this ratio to reflect the volatility of the collateral asset, DeFi platforms can create a buffer that allows for market fluctuations without triggering unnecessary liquidations. This approach ensures that liquidators are motivated by the prospect of profit, making the system resilient to market shifts while protecting the interests of all parties involved.

Auction Liquidations

Following the discussion on instant liquidations in DeFi, it's important to delve into another critical mechanism employed by DeFi platforms to manage loan defaults: auction liquidations. Unlike the straightforward process of instant liquidations, auction liquidations introduce a competitive bidding system, aiming to achieve more efficient and fair outcomes, particularly for larger loans that present a higher risk profile.

Instant liquidations, while efficient, can disproportionately benefit liquidators, especially in the context of larger loans. The profit from these transactions often scales with the size of the loan, creating a scenario where larger loans are more lucrative for liquidators but inherently riskier for borrowers. This dynamic can disadvantage borrowers with substantial loans, prompting the exploration of alternative liquidation mechanisms like auctions.

Auction liquidations are designed to mitigate the risks associated with instant liquidations by fostering competition among liquidators. The goal is to award the liquidation contract to the bidder willing to accept the smallest profit margin, ensuring a more equitable distribution of risk and reward. This competition can lead to more favorable outcomes for borrowers, potentially reducing the cost of liquidation.

Insurance Fund

To manage the risks associated with forced liquidation and potentially negative balances, some exchanges have instituted insurance funds. These funds serve as a financial buffer, covering losses from bankrupt positions and ensuring that profitable traders receive their due earnings. In scenarios where liquidation costs exceed the initial margin, the insurance fund absorbs the shortfall, protecting traders from debt liabilities.

Strategies for Mitigating Liquidation Risk

Effective risk management is paramount in leveraged trading. Utilizing stop orders and other protective strategies can help manage potential losses and preserve gains. Moreover, a deep understanding of the mechanics, strengths, and weaknesses of leveraged trading strategies is essential for long-term success and avoiding the pitfalls of forced liquidation.

In conclusion, forced liquidation is a fundamental aspect of leveraged trading in the cryptocurrency market, necessitating a proactive approach to risk management and a thorough understanding of trading terms and conditions. By employing strategic measures and maintaining an informed perspective, traders can navigate the complexities of leveraged positions and aim for sustainable trading success.

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Michael @ CryptoEQ
Michael @ CryptoEQ

I am a Co-Founder and Lead Analyst at CryptoEQ. Gain the market insights you need to grow your cryptocurrency portfolio. Our team's supportive and interactive approach helps you refine your crypto investing and trading strategies.


CryptoEQ
CryptoEQ

Gain the market insights you need to grow your cryptocurrency portfolio. Our team's supportive and interactive approach helps you refine your crypto investing and trading strategies.

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