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DeFi Loans Liquidation Risks

The cryptocurrency markets are going through massive sell-offs as the leading coins decline in double-digit values. Consequently, the digital currency market cap has sunk below the $1 trillion level from earlier highs of $3 trillion in 2022.

Ethereum, the fuel that drives the decentralized finance market, has lost half of its value in a month, plunging below the $1000 barrier. It last traded in this price range in January 2021. As investors in the blue-chip tokens fret over falling portfolio values, the crypto ecosystem deals with a larger problem; crypto liquidations.

The bear market has come along with a slew of margin trading and DeFi loan liquidations, wiping out most gains traders have made in the past year. As an illustration, on June 25, 2022, the continuous crash of ether and bitcoin prices led to the exchange liquidations of leveraged margin trading positions worth over $161 million daily.

Coinglass data shows over 57,000 traders had their positions liquidated in 24 hours, with the largest single liquidation of the day occurring at OKex. One liquidator salvaged a BTC-USDT-SWAP trade worth over $4 million.

Ether has the highest daily exchange liquidations at $2.78 million, followed by BTC liquidations worth $2.43 million. Liquidators are also highly active in DeFi platforms, as liquidations spike in lending and borrowing protocols.

DeFi liquidations occur every other day, but larger liquidation events can take place during extremely volatile bear market weather. As an illustration, on Black Thursday, March 12, 2020, MakerDAO liquidators demobilized 3994 collateralized debt positions (CDPs).

These CDPs held over $10 million worth of digital currencies that collateralized MakerDAO user loans. That day, liquidators redeemed $5 million worth of crypto assets on Compound and over $550K more on Aave.

Then in late January 2022, the ongoing crypto price plunge brought in a new wave of liquidations. On January 23, for instance, there were 1692 liquidations on Aave. MakerDAO had 95 liquidations at the time.

The ongoing bear market, however, has kept the liquidations momentum at a new high. As per Dune Analytics data, leading DeFi protocols have had over $37 million worth of liquidations in June 2022, as the sector’s total value locked dropped to $49 billion.

Compound liquidations lead at $149 million worth of debt liquidations, while Aave’s liquidation debt stands at $115 million.

What are DeFi liquidations?

Trustless, intermediary-free lending and borrowing are one of DeFi’s most potent use cases. Any token holder can leverage their idle crypto assets in lending platforms and earn yield. Borrowers also can access crypto-asset loans through smart contract borrowing.

They would, however, require collateral crypto assets to initiate smart contract CDPs and borrow lesser quantities of the assets provided by lenders. Collateralization is, therefore, an important factor in DeFi borrowing.

It is the issuance of valuable assets to secure credit. In traditional finance lending, borrowers use physical assets such as real estate or cars as collateral for credit. Lenders will seize these assets should the borrower default on loan payments. Banks only accept low-volatility assets as collateral on secured loans.

Decentralized finance protocols such as Mimo Protocol accept crypto assets such as ETH and BTC as deposit collateral. A PAR stablecoin borrower will deposit these assets in the Mimo Protocol vaults, create a CDP, and mint new PAR tokens.

Crypto collateralized lending, however, can only eliminate lending risk when the value of the collateral exceeds the loan’s value. High collateral to loan values gives borrowers easy access to working capital without the constant need to sell liquid assets.

Since DeFi lending leverages ultra-volatile crypto assets as collateral, DeFi lending is high risk. To illustrate this point, Ether, the crypto asset that collateralizes most DeFi loans, has had a 78% price correction since its November 10, 2021, high of $4,870.

In such instances, a rational borrower could abscond with loan assets since they could be worth much more than deposit collateral. As an illustration, a borrower holding 100 PAR stablecoins worth 100 Euro could prefer them to $99 worth of ETH.

Such instances could break the DeFi lending process. Since crypto-assets can plunge in minutes, lending protocols mitigate risks through hyper collateralization of loans. The Mimo Protocol vaults, for instance, have a Minimum Collateralization Ratio (MCR). A Mimo vault may use a 130% MCR to mitigate crypto volatility risks in the PAR lending process.

Consequently, borrowers need to deposit 130% collateral before opening up a PAR debt position. A common MCR on most lending protocols is 115%. The MCR gives the lender a buffer in volatile markets. It gives them adequate time to top up their MCR in falling markets or repay their lender, keeping the entire DeFi lending sector solvent.

Liquidation risks

That said, in many instances, the value of the collateral that backs most DeFi loans will drop below the MCR without any action from the borrower. This occurrence creates significant risks for lending platforms. First, the DeFi borrower does not incur additional costs when their loans become insolvent.

Secondly, Ethereum transactions have hefty gas charges, so the lending platform cannot close these loans for free. Moreover, when cryptocurrency collateral dips in value, it is not useful for loss mitigation, and the lending platform cannot resell it to recoup its loan in falling markets.

To get around this issue, DeFi lending platforms allow liquidators to come in and pay off any loan whose collateral has fallen below the MCR. Of course, they will seize your crypto assets deposit in the process. To this end, the borrower alone bears all market risks and the repayment costs of their loan.

The lending platform will sell your collateral at a discount to liquidators to incentivize quick sales in volatile markets. But liquidators do not have the best reputation in DeFi. Some pundits refer to them as “the silent killers of DeFi city… a brotherhood of pro-executioners, jacking in from anywhere in the world to keep the city solvent”.

If platforms did not adequately incentivize these third parties to prowl and bid on low-priced collateral, the crypto assets lending sector would halt. Lending platforms, therefore, reward these third parties that disincentivize loan under collateralization by levying liquidation fees on crypto loans.

The liquidators, therefore, earn fees from liquidation fees and could maximize gains from cheaply auctioned crypto loan deposits. PAR loans on the Mimo Protocol have a liquidation MCR that determines vault liquidation occurrences.

The protocol also levies a liquidation fee on PAR loans. You can avoid liquidations by maintaining a healthy MCR margin on your crypto debts. Raise your loan collateral values by depositing more crypto assets when the market turns.

Dangers of whale liquidations

Liquidator mechanisms vary across protocols. For example, some lending protocols may employ smart contract liquidation processes. These smart contracts close and sell collateral deposits in a single transaction. In addition, most protocols use third-party liquidators to ensure the decentralization and fairness of the liquidation process.

A liquidator is often a bot that monitors pending transactions on a blockchain, such as Ethereum. They will locate loans eligible for liquidation in a downtrend and quickly liquidate them. These liquidators often play by the rules, offering their services to keep the market afloat.

In extremely volatile markets, the liquidation process can create a player vs. player setting that attracts the shark liquidator. This liquidator will, for instance, scour blockchains seeking any trader that has highly leveraged positions.

They will then attack these positions forcing liquidations and earning massive gains in rewarding liquidation fees. When these grifters push high-value positions to liquidation, they could trigger a cascade of liquidations. Savvy traders could open and hold short positions to gain profits from the developing secondary price decreases.

This is why Celsius has had to add 2000 wBTC to its Maker loan to raise its loan’s liquidation price on June 13. The Celsius loan holds over 20,000 wBTC as collateral, whose value plunged alongside BTC values and would breach liquidation levels once BTC crossed the $20,272 price range.

Unfortunately, further falling prices forced Celsius to top up its collateral once more in 2,041, 1,501, and 499 wBTC batches on June 13 and 14, further lowering its loans liquidation threshold to $16,852 and increasing its MCR to 191.98%.

Elsewhere, on June 20, Solend, a Solana-based lending protocol, did the unthinkable and had its community vote to halt and take over a massive loan due for liquidation. Liquidation of the $108 million loans collateralized with SOL would plunge the Solana native token values to new lows in a lagging market.

The resultant scramble by liquidation bots would probably crash the unstable Solana network. The liquidation would also leave Solend in near SOL bankruptcy. “Liquidators would be especially active and spamming the liquidate function, which has been known to be a factor causing Solana to go down in the past, “ says one analyst. The Solend community held a controversial voting process that approved a proposal limiting borrowing to $50 million per account.

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