What is Liquidation in DeFi Lending and Borrowing?

Defi is popular because it offers numerous advantages, including high returns, flexible entry and exit, decentralization, and so on.

However, there are risks associated with these advantages. DeFi lending is an especially risky investment due to the high volatility of crypto-assets.

In this post, we’ll take a look at the risks and advantages of DeFi lending and compare it with the institutional lending model in the traditional financial market.

DeFi Lending and Borrowing

Lending protocols are essentially decentralized platforms that connect lenders and borrowers. It enables lenders to earn interest by depositing crypto-assets into the platform.

The concept of Defi interest is the same as it is with your bank, except that Defi lending protocols offer significantly higher APY returns than bank savings accounts. Also, the calculation of interest in DeFi protocols tend to be a little more technical than with traditional lending institutions.

On the one hand, it enables borrowers to borrow cryptocurrency in exchange for interest from the platform or other users. On the other hand, it allows users to earn interest by depositing their crypto-assets into the platform. The interest received by lenders is derived from the interest paid by borrowers.

Asset Collateralization

Collateralization is a fundamental concept in the financial industry. It simply refers to something you put up as a guarantee when borrowing money.

For example, if you take out a bank loan to buy a house, the house will serve as collateral. If you fail to repay your loan, the bank will repossess your home.

It’s the same in Defi. If you want to borrow some assets from the liquidity pool, you must provide the pool with some other assets as collateral. If you do not repay your loan, the protocol will not return your collateral to you. The collateral will be used to repay your debt to the liquidity pool.

Overcollateralization

To borrow cryptocurrency in DeFi, the borrower must deposit another crypto asset at a certain percentage higher value than what they borrow. In traditional finance, this is called an overcollateralized loan.

The stability of DeFi lending platforms like Compound, Aave, C.R.E.A.M., and MakerDAO is crucially reliant on overcollateralized accounts.

For example, the most common motive for a borrower is to leverage more assets for trading purposes. Leverage in lending means to borrow money and using it to ‘doublr-down’ on another investment.

From the borrowers position, leveraging overcollateralized loans is only profitable if the end investment raises in value faster than the interest you owe on your debt.

Furthermore, if the collatoralized asset’s value falls below the total debt price, it makes no sense for the borrower to repay the loan, causing the loan to become insolvent.

Therefore, the loan is good as long as the collateral is worth more than the amount borrowed. It is in the protocol’s best interest to ensure that liquidation occurs before the price changes too drastically.

What is “liquidation” in DeFi?

In traditional finance, liquidation occurs when a company or group must sell some of its assets at a loss to cover a debt.

DeFi liquidations are similar in that users take out debt from a protocol and provide crypto assets as collateral to back the debt.

Thus, DeFi liquidation is the process by which a smart contract sells crypto assets to cover the debt.

Loan-To-Value Ratio

Liquidation is basically a stop-loss for DeFi lenders. The liquidation threshold protects the lender from a sharp price drop, which could lead to under-collateralization followed by liquidation.

If the borrower’s collateral value falls closer to your debt value or is unable to support your debt value, the protocol will allow someone else to repay your debt, at a discount, in exchange for the collateralized asset.

Thus, liquidation also works as a penalty for borrowers, and the amount of assets sold for a discount depends on the assets used as collateral.

Liquidators

The DeFi lending platforms offer hefty incentives, also known as liquidation bonuses, to liquidators-those who buy the discounted collateral and cover the account’s debt.

In practice, however, due to gas wars between liquidators, a big part of the incentives end up with the Ethereum miners, because they decide which liquidator wins the transaction and the included discount.

Liquidators often develop bots to liquidate loans faster so to earn more bonuses.

Liquidation Crisis

However, once the price drops below the liquidation threshold, and the collateral is sold at a discounted price, the market value of the collateral asset may drop even further.

This can lead to a chain reaction of liquidations on a particular cryptocurrency.

Considering the risk of purchasing a declining valued asset, liquidators are less likely to participate when market conditions are sub-optimal.

If the price of the asset drops too far, liquidators will drop out completely, leaving the DeFi lenders take huge losses, in what’s known as a market liquidation crisis.

Liquidity Pools

Liquidity pools incentivize liquidity providers to stake tokens at risk to provide liquidity for otherwise unexchangeable tokens.

When a user liquidates their token asset holdings, smart contracts automatically distribute the exchange fees to the pool’s liquidity providers in proportion to the overall liquidity staked in that specific pool.

Weighted Pools

Weighted Pools are a generalization of the standard constant product AMM, popularized by uniswap.

Each pool can contain several different tokens — which vary by protocol — and each token is assigned a weight defining what fraction of the pool is made up of each asset.

As the price of each token changes, traders and arbitrageurs rebalance the pool by making swaps. This maintains the desired weighting of the value held by each token whilst collecting trading fees from the traders.

Oracle Pools

These are a subset of weighted pools that hold two tokens and provide price oracles for the tokens they hold.

The protocols usually have no control over these dependencies, which means that if any of them is compromised, it will have a direct impact on the protocol that uses them.

Stable Pools

For certain assets that are expected to consistently trade at near parity (e.g. different varieties of stablecoins or synthetics), a more efficient design is the StableSwap AMM as popularized by Curve.

These pools allow for larger trades of these assets before encountering a significant price impact.

MetaStable Pools

These are a generalization of stable pools that contain tokens with known exchange rates. They use equations similar to those of stable pools, but can be used to facilitate swaps between tokens that have gradually shifted prices.

Liquidity Bootstrapping Pools

These pools are useful for launching tokens and swapping large amounts over time. They feature weight-shifting mechanisms that result in high starting prices with continuously changing selling pressure.

How do you avoid liquidation risks?

Usually, stablecoins are mostly used for borrowing, while volatile assets which users are long on are mostly used as collateral.

Borrowers should always maintain a healthy margin between the collateral and borrowed assets, especially if the collateral is a volatile asset. To avoid liquidation, you can raise your collateral value by depositing more collateral assets or repaying part of your loan.

Although other protocols can limit risks and cut losses as early as possible through mechanisms such as limiting supported asset types, setting loan-to-collateral ratios, and enforcing close monitoring of loans with a quick liquidation process.