Everything you need to know about liquidations in DeFi
DeFi money markets are the building blocks of any blockchain. Crypto holders earn interest on their tokens by depositing them on platforms like Aave, Compound, or Nostra while traders can borrow such tokens at a cost determined by their supply and demand.
Loans offered on money markets are overcollateralized. This means borrowers can only borrow crypto worth less than the value of their collateral at the time of the loan. Due to the volatile nature of cryptocurrencies, the collateral asset value may drop or the borrowed token value may appreciate, causing the loans to become undercollateralized. It is then in the best interest of the protocol to liquidate the loan to repay the lender before there are any further changes in the price.
This educational blog will cover the importance of liquidations in DeFi and some interesting stats we have seen in the past few years.
Liquidations in DeFi
DeFi liquidations are similar to TradFi liquidations, where a company or an individual is forced to sell their assets to repay their debt.
If the value of the borrower’s collateral falls below the loan amount, it is more lucrative for borrowers to abscond with the loaned asset than repay the debt, leaving lenders underwater. Thus before the loan turns bad protocols allow others (i.e. liquidators) to step in and repay the debt at a discount in exchange for the collateralized asset.
Many liquidators compete to repay the bad debt because of the discounts that come with it. To prevent bad debt from accruing on the platform, money markets allow liquidators to buy the assets of undercollateralized loans at a discounted value, thus making the market liquid again. As the liquidation space has become more competitive, many liquidators have started to developing liquidation bots to assist them in liquidating loans faster.
How do liquidations work?
To become a liquidator, you need:
- a bot that monitors pending Ethereum transactions and finds loans eligible for liquidation;
- smart contracts that allow liquidations
Ideally to ensure low-risk profit, additionally, you will need:
- a decentralized exchange (DEX) that can be used to buy the debt and/or sell the collateral immediately;
- smart contracts that allow the sale of the collateral to be automatically executed in a single transaction
While some protocols provide their own off-the-shelf tools to facilitate liquidations, others rely on third-party services.
Liquidation mechanisms
A good liquidation mechanism is one that prevents money markets from being stuck with bad debts by allowing liquidations to occur at the lowest possible cost to liquidators while protecting borrowers from harsh liquidation penalties.
The most important features can be identified as:
- Increasing incentives for liquidators as the collateralization level drops
- Allowing liquidators to repay only the portion of borrowers’ debt necessary for the position to return to a healthy state
Another important metric is the loan-to-value (LTV) ratio which describes the maximum amount of a secured loan based on the market value of the asset pledged as collateral. A higher LTV means better capital efficiency while a lower LTV means poor capital efficiency.
Liquidation procedures allow liquidators to buy the collateral at a discounted rate. This ensures the protocol can remove its bad debt over time. To do this, some of the collateral needs to be present in the pool in order for the transaction to take place. A high utilization ratio for a pool prevents this from happening. This is because a high utilization ratio for a certain pool means that there is no asset available to be transferred to the liquidator’s wallet. Nostra allows liquidators to directly purchase the debt positions — Nostra dToken. This improves capital efficiency on the platform. A liquidator will only be able to purchase a debt position if his health factor continues to stay above 1 after acquiring the debt.
Lastly, liquidation mechanisms that only penalize borrowers enough to incentivize liquidators are always preferred to excess penalties that lead to undesired liquidations on the platform.
Some of the most popular liquidation mechanisms are as follows:
Fixed liquidation discount model
This is one of the simplest and most common liquidation meodels in the industry. Loans on protocols like Aave and Compound get instantly liquidated in a single block transaction up to a threshold for a predetermined discount. This discount depends on the type of asset used as collateral. The higher the volatility of the asset, the greater the discount on it.
The advantage of this model is that the liquidation discount and profits are known before the transaction takes place. With more liquidators entering this space, this has led to gas wars, especially during times of extreme market volatility, resulting in:
- liquidators paying a premium on top of the average gas fees to outbid other liquidators;
- congestion in the Ethereum network caused by gas wars; and
- borrowers unable to re-collateralize their positions resulting in further liquidations
A significant drawback of this model is the close factor set by some leading protocols. The close factor is the percentage of a borrower’s collateral that can be liquidated at the time of liquidation. For example, a protocol might keep its close factor as high as 40%. The health factor of the position might return to normal by liquidating only 20% of the collateral, but a liquidator will try to exploit the borrower by liquidating them up to the 40% threshold and maximize profits.
An even worse outcome would be when a borrower has a health factor of 0.8 and a liquidator liquidates the borrower till the health factor improves to 0.99. They can then again liquidate the borrower by another 40% which will be completely detrimental to any borrower.
This liquidation model is therefore considered unfavorable for borrowers. Additionally, low close factors might also lead to multiple liquidation transactions, leading to high transaction costs and network congestion, resulting in a decline in profits.
Another drawback worth mentioning is the fixed discount for all collateral sizes. A small position would sometimes be unprofitable for a liquidator and this might lead to bad debts for the protocol.
Stability pool-based liquidations
Protocols like Liquity have managed to come up with a new stability pool based liquidation model where, instead of relying on outside liquidators, the stability pools act as a source of liquidity to repay the loans and acquire assets at a discounted value.
Take the example of Liquity where the stability pool, funded by their native stablecoin LUSD, repays any debt when a loan falls below the 110% collateralization ratio. The LUSD from the pool is used to purchase the ETH collateral at a discounted value and it is then distributed amongst the LPs on a pro-rata basis.
The main benefits of stability pools is the availability of funds and the low transaction costs which only consist of internal token transfers. However, there is a major drawback of the opportunity cost of the capital where profits from liquidations are shared on a pro-rata basis and not on a time-weighted basis. Another drawback is that liquidation bonuses are not enough to remunerate LPs adequately. Hence, stability pools force protocols to issue incentives on top of that.
Dutch auctions
Nostra and Euler use the Dutch-like auction model for liquidations on their platforms. A Dutch auction is a type of auction where the auctioneer begins with a high asking price when selling, and keeps lowering until a participant accepts the price. Similarly, Nostra and Euler reduce the collateral price as the health factor of the position decreases. The profit of liquidators increases as the collateral price decreases.
The biggest advantage of the Dutch auction liquidation model is that it allows the discount to vary depending on the health factor of the borrower. This discount may increase or decrease as time goes by.
Another advantage of the Dutch liquidation model over the fixed liquidation discount model is that it allows liquidators to decide the true value of the collateral, thus changing the discount value for the collateral depending on the size of the position. If the position size is small, the liquidator will wait for a greater discount to cover the transaction cost and make the desired profits. Smaller loans can therefore have a higher discount rate. Similar arguments can be made during times of network congestion where the network gas fees shoot up, resulting in a high discount on the collateral to cover for the increase in transaction costs.
Read more about Nostra and the liquidation mechanism here: https://docs.nostra.finance/nostra-overview/liquidations
How to avoid being liquidated?
One of the best ways to protect your collateral from getting liquidated is by borrowing stablecoins and depositing tokens that you are long on.
Even if it’s not a stablecoin, make sure you borrow a token that leaves your health factor in a comfort zone to protect yourself from being liquidated. If you feel the price of your collateral will fall, you can also add more assets to the pool to avoid being liquidated.
All borrowers must regularly check their health rate, top up collateral, and/or lower their debt whenever approaching a health factor of 1.
Some protocols like Nostra also allow users to use up to 255 subaccounts. These subaccounts can be used to deposit different kinds of collateral and to borrow different asset types. On Nostra, every user will be able to borrow a highly volatile and illiquid token like $SHIB in a separate subaccount to protect the rest of their portfolio from contagion risk.
Conclusion
Liquidations and liquidators are definitely the core pillars of any money market and that have helped scale this category to $15 billion TVL. Well-functioning liquidation mechanisms allow lending protocols to sail smoothly even through stormy weather. The Nostra money market has been designed to align incentives among all the parties involved to maximize the collective utility of lenders, borrowers, and liquidators.
Disclaimer
The information provided in this article is provided for informational purposes only and does not constitute, and should not be construed as, investment advice, or a recommendation to buy, sell, or otherwise transact in any investment, including any products or services, or an invitation, offer, or solicitation to engage in any investment activity. You alone are responsible for determining whether any investment, investment strategy, or related transaction is appropriate for you based on your personal investment objectives, financial circumstances, and risk tolerance. In addition, nothing in this article shall, or is intended to, constitute financial, legal, accounting, or tax advice. We recommend that you seek independent advice if you are in any doubt.
