Liquidation in Decentralized Finance (DeFi)

Liquidation in Decentralized Finance (DeFi)

Definition: In the world of decentralized finance (DeFi), liquidation is a process where a borrower's collateral is automatically sold off to cover their outstanding loan. It's like when you take out a loan to buy a house, and if you can't make your mortgage payments, the bank can take the house. In DeFi, instead of a house, it's cryptocurrency, and instead of a bank, it's a smart contract.

Key Takeaway: Liquidation protects lenders in DeFi by ensuring they get repaid, even if the value of the borrower's collateral decreases.

Mechanics of Liquidation

DeFi lending protocols allow users to borrow assets by providing collateral. This collateral is often another cryptocurrency. For example, you might deposit Ethereum (ETH) as collateral to borrow stablecoins like DAI. The protocol sets a Loan-to-Value (LTV) ratio. This ratio determines how much you can borrow based on the value of your collateral. If the value of your collateral falls, or the value of the asset you borrowed increases, your LTV increases. If your LTV exceeds a predefined threshold (the liquidation threshold), your position becomes eligible for liquidation.

Here's a step-by-step breakdown of how liquidation works:

1. Collateralization: A user deposits collateral (e.g., ETH) into a DeFi protocol like Aave or Compound.
2. Borrowing: The user borrows another asset (e.g., DAI) based on the LTV of their collateral.
3. Market Fluctuations: The price of the collateral asset changes due to market volatility.
4. LTV Monitoring: The protocol constantly monitors the LTV of the user's position.
5. Liquidation Trigger: If the LTV exceeds the liquidation threshold (e.g., 80%), the liquidation process is triggered.
6. Liquidation Execution: The protocol automatically sells the borrower's collateral to repay the loan and any associated fees. This is often done via an auction or a direct sale on a decentralized exchange (DEX).
7. Penalty: Liquidators (who execute the liquidation) often receive a discount on the collateral, and the borrower may lose a portion of their collateral as a penalty.

Liquidation Threshold: The point at which a borrower's collateral is sold to cover their loan.

Loan-to-Value (LTV): The ratio of the loan amount to the value of the collateral.

Trading Relevance

Liquidation is crucial for understanding risk in DeFi. It directly impacts how traders and investors strategize. Traders often use leverage in DeFi, which amplifies both potential gains and losses. Leverage increases the risk of liquidation. If you're using leverage, knowing the liquidation thresholds of the protocol you're using is critical.

Here's how it affects trading decisions:

• Risk Management: Traders must actively manage their risk. This includes monitoring their positions, setting stop-loss orders (though not all DeFi protocols support stop-loss orders directly), and using conservative LTV ratios.
• Market Volatility: Increased volatility increases the risk of liquidation. Traders need to be aware of market conditions and adjust their positions accordingly.
• Opportunities: Liquidations can create opportunities for savvy traders. Liquidators can purchase collateral at a discount. Also, sudden liquidations can create short-term volatility, which can be traded.

Risks of Liquidation

Liquidation presents several significant risks:

• Loss of Collateral: The primary risk is the potential loss of collateral. If your position is liquidated, you lose a portion, or all, of your collateral.
• Market Slippage: During liquidations, especially during periods of high volatility, the collateral may be sold at a price significantly lower than its market value due to slippage, exacerbating losses.
• Protocol Risk: Bugs or vulnerabilities in the smart contract of the DeFi protocol could lead to unexpected liquidations or exploit the liquidation mechanism.
• Gas Fees: High gas fees on the Ethereum network can make it costly to manage your position, increasing the risk of missing the opportunity to add more collateral or repay a loan to avoid liquidation.

History and Examples

Liquidation has been a core feature of DeFi since its inception. Early examples of DeFi liquidations occurred on platforms like MakerDAO, the first major DeFi lending protocol.

• The Black Thursday Crash (March 2020): During the market crash of March 2020, the price of ETH plummeted, triggering a wave of liquidations across DeFi platforms. This event highlighted the risks of leverage and the importance of robust liquidation mechanisms. The extreme volatility led to cascading liquidations and network congestion, causing problems in the execution of liquidations.
• Aave and Compound: These platforms have sophisticated liquidation mechanisms, including liquidation bots that monitor positions and automatically liquidate under-collateralized loans. The LTV ratios and liquidation thresholds vary depending on the asset and the protocol.
• Recent Events: The Terra/Luna collapse in May 2022 showed that algorithmic stablecoins can fail. This caused massive liquidations across DeFi, as collateral tied to the Terra ecosystem lost value. It highlighted the risks associated with complex DeFi protocols and the potential for cascading liquidations during market crashes.

Understanding liquidation is essential for anyone participating in DeFi. It's a critical mechanism for maintaining the financial integrity of these platforms. By understanding the mechanics, risks, and trading implications of liquidation, users can navigate the DeFi landscape more safely and make informed investment decisions.