DeFi Liquidation Explained

Jun 3, 2022
Read 4 min
DeFi Liquidation Explained
Key Takeaways:
— DeFi lending protocols offer investors and traders a brand new way to access loans (outside of traditional finance) while offering lenders a way to earn more on their crypto holdings.

— A borrower has to put up a crypto asset as collateral for the loan – but since that collateral might change in value (thanks crypto volatility) borrowers face an increased chance of their loan going into liquidation, in which case they lose this collateral.

— This leads to unique risks for the borrower in DeFi, as well as for the space as a whole. Here, we tackle DeFi liquidation so you know how to manage the risks yourself.

Borrowing in DeFi opens new options for the unbanked – not to mention the chance for investors to leverage their position and maximize their gains – but it also carries unique risk. Here, we explain DeFi liquidation, how it works and what risks it poses to you and the industry more broadly.

Although lending and borrowing is an age old part of finance, in the crypto environment there are some unique challenges involved, and with them, some pretty big consequences. In this article, we’re exploring one of the key risks that you need to know about if you’re using a borrowing protocol in the DeFi space. Lock in, we’re looking at liquidation.

First, the basics: what exactly is liquidation?

The premise of borrowing is universal: you need money for something now, and you’ll pay it back later – plus extra – to whoever is willing to lend it to you. 

To give the lender security, you’ll do one of two things. Either (a) need to show a good credit score to prove that you are trustworthy and can pay back your loan or (b) use something called collateral. 

Collateral gives the institution a sure fire way of recuperating their money from you, even if you can’t make your repayments; they simply sell the collateral instead. This is known as liquidation. 

Why Your Collateral is at More Risk in DeFi

In DeFi, liquidation is a tricky old business. Why? Because the value of cryptocurrency is volatile. This means a lack of certainty about how much the crypto collateral you provided will be worth in a day or a week. If the collateral itself falls in value, it’s no longer useful for mitigating loss. 

So to get around this, lending protocols (or the smart contracts that govern them) include an extra condition, and it means that you, the lender, bear the risk of the market, as well as the repayment of your loan. Here’s how it works.

DeFi Liquidation: An Example

Say you’ve taken out a loan on a lending protocol,and you gave X amount of Ethereum as collateral. If the value of that collateral goes below a certain point (something called the liquidation threshold) the protocol will automatically liquidate your loan – even if you’ve paid most of it off – selling off your collateral to recuperate their costs before the value drops further.

What does this dynamic mean for borrowers?

What’s unique here is that this will happen even if the repayments are still being made as normal. You, the lender, are at the whims of the market.

The bottom line? No matter how much of your loan you’ve paid off, there is always a chance that precious collateral isn’t coming back., due to price volatility.

What does it mean for DeFi more broadly?

It might seem like DeFi puts all the risk onto the borrower, but the volatility of crypto means a bigger risk for lending protocols too. It your loan liquidates, it’s not ideal for a lending protocol to be left with collateral assets to sell – there’s always a risk that nobody will want to buy those assets, leaving the protocol unable (still) to recup their loan. 

To get around this, when their smart contract sells your collateral, it does so at a discount in order to make a quick sale – in DeFi, lending protocols also allow third parties to “bid” on the collateral they’re selling, and offer incentives to potential buyers. This “race to the bottom” negatively impacts the value of whatever cryptocurrency the collateral was in. 

So in short, the way liquidation is managed in DeFi is not only risky for borrowers like you and me, but has an impact across the board, on lenders and currencies generally. This unique marketplace is something that needs to be borne in mind if you’re seeking to borrow yourself.

Can you avoid liquidation risk (as a borrower)?

If the collateral is volatile (which is the case in crypto), you should maintain a healthy margin between yur collateral and the asset you’re borrowing. If the market starts moving, you can also raise your collateral value by depositing more collateral assets or start repaying the loan to avoid liquidation.

DeFi is an ecosystem with its own rules and risks, and while you can’t change those, you can arm yourself to navigate the space safely, by learning how it works. Understanding how to read a smart contract is a great start, because it will allow you to investigate protocols you’re interacting with, and their conditions. 

Similarly, making sure you use a wallet that gives maximum transparency as you engage with those smart contracts will enable you to understand what you’re agreeing to each time you interact.

Knowledge is power

While there are risks involved, lending protocols offer both lenders and borrowers advantages, not least, access to financial services that might not have been available in the traditional system.

Knowing the risks involved is one of the first steps in mitigating them. At Ledger, we know there’s a whole lot of power in knowledge and we’re here to make sure you step into the digital space with as much insight as possible. See you next time, fren!

Knowledge is Power.

Trying to make your way in crypto – but not sure where to start? Here, we don’t tell you how to get rich, but we do tell you a few facts that might help you navigate the space. Thanks, School of Block!

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