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Liquidation Bots

August 8, 2023

Liquidation in DeFi can often have a negative connotation due to the unfortunate stories shared by some crypto traders. However, this process plays a crucial role in maintaining the safety of the crypto market. It enables platforms to clear risky loans and positions that can affect asset prices and the overall state of decentralized platforms. As with many automated processes in crypto, DeFi platforms often use liquidation bots to help with it.

In this regard, let's take a closer look at DeFi lending, the liquidation process, and bots-liquidators.

DeFi Lending & Liquidation

Over the last few years, several decentralized lending protocols have emerged on Ethereum and other blockchains. These protocols offer cryptocurrency owners a way to lend or borrow funds in a trustless manner. Though these platforms differ in their approach to the market, the types of crypto assets they offer, and their loan terms, they all operate on the same basic principles. The borrower provides collateral in a smart contract and receives a smaller amount of a different asset from the lender or platform.

This system allows borrowers to access capital without selling their less liquid or temporarily unneeded assets. However, a problem arises when the value of the collateral drops. It may lead borrowers to flee with the loaned assets, leaving lenders with losses. Since the prices of crypto assets fluctuate frequently, it presents a significant issue.

Lending protocols require over-collateralization to reduce risks, often at 150% of the desired amount. The added amount provides a sufficient cushion before the value of the collateral drops below the loan amount. If the value of the collateral falls below this level, the borrower can either top it up or sell it to repay the lender and keep the system functioning.

However, another issue arises since neither transactions nor liquidations are free. Consequently, lending protocols must incentivize liquidators to keep the system solvent. Some platforms impose additional fees on liquidations that go to the liquidators, compensating them for the risks and costs associated with the process. Some sell collateral to liquidators at a discounted price. And some lending companies use both methods to ensure the system's solvency.

Liquidation Bots 

Liquidations require certain essential elements, although the specifics may vary depending on the protocol. These include a bot that tracks transactions and searches for loans to liquidate, a decentralized exchange that quickly sells the liquidated collateral, ensuring a profit for the liquidator, and a smart contract that enables the liquidation and sale of collateral in a single transaction.

Some protocols have pre-built tools that make liquidation easier, while others rely on a network of custom liquidation bots. In the latter case, any crypto holder can try their hand at helping to liquidate debts.

Possible Challenges

There are several challenges you need to consider before becoming a liquidator. Firstly, liquidation bots require experience in both crypto and programming, making them unsuitable for beginners. 

Secondly, liquidators need financial resources to perform liquidations. They must create an account on a chosen platform and deposit certain funds or take flash loans to quickly liquidate positions and repay the debt in the same transaction.

Thirdly, competition is a significant challenge for liquidators. The same reasons that make liquidation attractive to crypto enthusiasts, such as low financial barriers to entry, high margins, and pretty easy tools, also attract more people daily, leading to rising competition and reducing margins for existing liquidators.

Borrowers are also becoming more sophisticated in their tactics, using bots to sell borrowed assets if loans become too risky and re-collateralizing loans in one transaction to avoid liquidation. Such tools may lead to a decrease in liquidators' profits in the long term.

In times of insufficient liquidity, liquidation bots can experience difficulties. For bot owners, this results in downtime, and for lending platforms, it can lead to debts accumulating within their systems, increasing the risk of bankruptcy.

Finally, when liquidation bots use flash loans to close debts, it may sometimes negatively affect the prices of the involved assets. By taking flash loans, bots can cause slippage in the price of a liquidated asset. If the slippage exceeds the offered liquidation bonus, bots will likely not execute the transaction, as they are often designed to avoid losses whenever possible.

Final Thoughts

Despite being viewed negatively by some cryptocurrency users, liquidation plays a crucial role in ensuring the safety of the DeFi market. By enabling platforms to clear risky loans and positions, it prevents any adverse impact on asset prices and the overall state of decentralized platforms, helping the DeFi lending market grow safely. Though liquidation may not be suitable for amateur cryptocurrency users, more experienced enthusiasts can benefit significantly from liquidating debts with bots.

The Kinetex team plans to develop bots that can analyze the market and promptly adapt to ever-changing trends. These self-learning bots will assist Kinetex resolvers in performing transactions automatically while providing users with the quickest execution times and most profitable rates.

Kinetex Network: Website | Kinetex dApp