What Is DeFi Liquidation: Meaning, Incentives, & Risks
What is DeFi liquidation?
Key Takeaways
- Decentralized finance (DeFi) liquidation occurs when the value of a borrower’s collateral on a platform drops below a predefined threshold, triggering an automatic sale.
- This process helps keep DeFi platforms stable by making sure loans have enough collateral to cover them.
- Crypto liquidators earn incentives for participating by purchasing collateral at a discounted price.
- Due to market volatility, DeFi liquidation can pose risks for borrowers and liquidators.
“Crypto decentralized finance (DeFi) liquidation occurs when the value of a borrower’s collateral—an asset provided as security for a loan—falls below the agreed limit and is automatically sold.”
DeFi has grown rapidly in recent years, offering financial services without traditional intermediaries. In this space, liquidation is crucial, especially in lending and borrowing.
Understanding how crypto DeFi liquidation works and its incentives and associated risks is key for anyone involved in DeFi, which his article covers.
DeFi Liquidation, Explained
Crypto DeFi liquidation is essential for maintaining the health of decentralized lending platforms such as Binance Smart Chain or Aave. If a borrower’s collateral loses too much value, it no longer covers the loan, posing risks to the lender and the system. Crypto liquidation ensures that the protocol can recover the loan amount, even if the borrower cannot repay.
In other words, DeFi liquidation is similar to a margin call in traditional finance because, in both cases, when the value of the borrower’s collateral falls below a certain threshold (the liquidation price), the assets are sold to cover the debt or loan. Both processes aim to protect the lender by ensuring the loan is repaid if the collateral loses too much value.
In most DeFi lending protocols, when someone takes a loan, they must deposit cryptocurrency as collateral. If the borrower can’t repay the loan or if the value of the collateral drops too much, the protocol automatically sells the collateral.
How Is Defi Liquidation Different From Traditional Liquidation?
DeFi liquidation differs from traditional liquidation in key ways that are essential to understanding why it occurs.
- Automation: In DeFi, liquidation is typically automated through smart contracts, meaning no human intervention is needed. In traditional finance, a margin call often requires manual action by the borrower or broker.
- Transparency: DeFi liquidation is fully transparent, as all transactions occur on a public blockchain. In traditional finance, liquidation details may not be as easily accessible or visible to everyone.
- Decentralization: DeFi operates without intermediaries, meaning that crypto liquidation happens directly through code, while traditional finance relies on brokers or institutions to manage liquidations.
Why Do Liquidations Occur in DeFi?
Several factors can lead to crypto liquidation, including:
- Market volatility: Sharp price swings in cryptocurrencies can quickly reduce the collateral value, making volatility a key factor.
- Low collateralization ratio: When the value of a loan’s collateral is less than the platform’s required threshold, it can trigger liquidation.
- Platform-specific rules: Each DeFi platform can enforce a unique collateralization process and a specific liquidation threshold, which can trigger DeFi liquidations.
In DeFi, borrowers are typically required to provide over-collateralization, which means their collateral must exceed the loan amount. Depending on the platform, the minimum collateralization ratio usually ranges from 100% to 150%.
For example, MakerDAO requires a 150% collateralization ratio for loans involving assets like ETH to protect against price fluctuations in the volatile crypto market. This means that for a $100 loan, a borrower must provide at least $150 worth of cryptocurrency as collateral to ensure the platform remains protected if the value of the collateral drops.
A high collateral ensures that even if the value of the collateral drops, the platform can still recover the borrowed funds. However, crypto liquidation is triggered to prevent losses if the collateral’s value falls too much.
The Liquidation Process
The liquidation process is automatic and transparent. When the collateralization ratio falls below the platform’s required level, the platform’s protocol automatically triggers crypto liquidation. It sells enough of the borrower’s collateral to cover the loan and any additional fees.
Other users, or liquidators, purchase the collateral, often at a discount, to incentivize them to step in and keep the system balanced.
How Does a Liquidation Work?
The process of DeFi liquidation starts with the protocol’s tracking and identification of loans at risk. Once it flags a specific loan, liquidation is carried out through the following steps:
- Liquidation auction: The protocol opens an auction for the borrower’s collateral.
- Liquidators bid: Liquidators bid to purchase the collateral at a discount.
- Completing the auction: The highest bidder wins the collateral, and the funds from the sale are used to repay the loan and any accrued interest.
What Is the Liquidation Price?
The liquidation price refers to the value at which a borrower’s collateral is liquidated. The platform sets this price based on the initial loan terms, the value of the collateral, and the loan’s size.
Example of a Liquidation Process
Imagine a borrower takes a loan of 1,000 DAI (a stablecoin formerly known as SAI) on a DeFi platform and uses 2 ETH as collateral. If the platform requires an average of 150% collateralization ratio, the borrower needs to maintain at least $1,500 worth of ETH as collateral to keep the loan secure.
If the price of ETH starts to drop and the value of the borrower’s 2 ETH falls below $1,500, the liquidation process begins. The liquidation price in this example would be the price of ETH at which the collateral value is no longer sufficient to maintain the required collateralization ratio.
So, if ETH falls to a price where the borrower’s 2 ETH is worth less than $1,500, say $750 per ETH (which is very low in the trending market conditions), the loan is at risk, and the liquidation price would be $750 per ETH in this scenario. At this point, the protocol sells part or all of the ETH to cover the loan.
Who Benefits From Liquidations?
The liquidators are the primary beneficiaries of a DeFi liquidation process. However, there are other important benefits for the lenders and the platforms.
- Liquidators: By buying collateral at a discounted price and reselling it at a higher market value, liquidators can profit.
- Lenders: Liquidations protect lenders by repaying loans in full, reducing the risk of defaults.
- Platform: Liquidations maintain the stability of the DeFi system by preventing defaults and keeping the platform solvent.
Incentives for Liquidators
By buying collateral from loans at risk of default, liquidators help ensure the loans are repaid, preventing borrowers from defaulting entirely. This action keeps the lending platform solvent or able to meet its financial obligations.
It protects other users from the negative impacts of defaults, such as reduced liquidity or destabilized lending markets. As a result, liquidators become key participants in maintaining a healthy ecosystem, which is an incentive in itself.
Additionally, to attract liquidators, protocols offer financial incentives while ensuring the platform can recover its funds, and these include:
- Discounted collateral: Liquidators can purchase collateral at a discount, often below market value.
- Rewards in tokens: Following some tokenomics logic, Some platforms reward liquidators with native tokens, such as BNB, for example, or other forms of compensation.
- Fee compensation: Some platforms compensate liquidators with a portion of the liquidation fees charged during the process, providing another revenue stream.
It is important to note that liquidators must act quickly to exploit these opportunities. DeFi space is highly competitive, so the fastest liquidators often secure the most profitable deals.
For that reason, certain platforms may give liquidators priority access or better chances in auctions, enhancing their ability to secure profitable deals.
Risks of Liquidation
While liquidation is essential for maintaining DeFi platform stability, it comes with risks.
- Fees: DeFi platforms often charge fees during liquidation, increasing the borrower’s cost.
- Market Risk: This category includes factors like market and price volatility, as well as the difficulty of selling collateral during times of stress, which can affect liquidators.
- Exploitation: Flash loan attacks are a specific type of exploitation by malicious actors that can be used to trigger liquidations.
While these risks are inherent to DeFi liquidations, borrowers can mitigate them by:
- Maintaining adequate collateralization.
- Monitoring market conditions.
- Using reputable platforms.
- Diversifying collateral.
By understanding these risks and taking appropriate measures, borrowers can minimize their exposure to liquidation and participate in DeFi lending more safely.
Conclusion
DeFi liquidation is essential for maintaining the stability of decentralized lending platforms by ensuring loans are backed by sufficient collateral, making it a crucial part of the DeFi ecosystem. Crypto liquidations occur when the value of a borrower’s collateral falls below a required threshold, triggering an automatic sale.
Liquidators purchase the collateral at a discount and resell it for profit. The liquidation process protects lenders or platforms by guaranteeing loan repayment and minimizing the risk of defaults.
As a result, the system benefits by maintaining solvency and preventing cascading failures.
However, as with many other processes in the DeFi ecosystem, crypto liquidation has risks for both liquidators and borrowers, and users should be aware of these.
FAQs
People become liquidators in DeFi because they can buy assets at a discount when a loan is liquidated and sometimes earn extra rewards or tokens. This makes liquidating profitable and worth their effort. The liquidation price is the point at which the value of a user’s crypto collateral drops so much that it gets sold to repay their loan. This price is determined by how much the user borrowed and the value of the collateral. If the collateral’s value falls below a certain level, the system or protocol automatically sells it. Borrowers can protect themselves from liquidation by providing more collateral than required and regularly monitoring the value of their assets. If prices drop, they can add more collateral or repay part of the loan to reduce liquidation risk.What are the incentives for people to become liquidators?
What is a liquidation price, and how is it determined?
How can borrowers protect themselves from liquidation?
