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Everything You Wanted to Know about Liquidation

January 16, 2024

In cryptocurrencies' unpredictable and constantly changing world, creating and sustaining balance is crucial in all aspects, including lending and borrowing systems. Although liquidation has gained a negative reputation because of the unfortunate experiences of some crypto traders, it is an essential tool for maintaining the mentioned balance, along with the safety of the crypto market. 

By eliminating dangerous loans and thereby preventing significant losses, the liquidation process enables projects to ensure the robustness of lending protocols and avoid the damaging influence those loans might have on asset prices and the overall state of DeFi. In this exploration, let's look at what liquidation is in the crypto space, how it works, and what risks it carries.

Understanding Liquidation

DeFi gave crypto users many exciting opportunities, offering them products and services that can broaden their financial horizons and provide extra means for a passive income, including lending protocols. While the platforms may differ in their approach to the market, types of crypto assets offered, and loan terms, they all operate on the same underlying principles. The borrower puts collateral into a smart contract and receives a different crypto asset in return, albeit in a smaller amount.

This system enables borrowers to access capital without completely giving up assets that might be less liquid or unwanted for the time being. Such assets can be used as collateral for loans and brought back when they become needed again. However, a major issue arises when the value of the collateral rapidly sinks. In such cases, borrowers may be tempted to flee with the loaned assets, leaving the depreciating collateral behind. Due to the regular fluctuations in the prices of coins and tokens, such temptations may appear quite frequently. So, how can we make the lending system more resilient and sustain its seamless and adequate operation while continuing to foster accessibility? Liquidation is an answer. 

In the world of crypto, liquidation is a process that involves the selling off of a borrower's assets to repay a loan when the value of those assets falls below a certain threshold, which is commonly referred to as the liquidation threshold or collateral ratio. The primary objective of liquidation is to safeguard lenders' capital and promote the stability of lending platforms by minimizing the risk of default. By ensuring that loans are adequately collateralized and closed at the right time, liquidation decreases the likelihood of substantial losses, which is particularly important in the volatile crypto market. 

When the collateral ratio of a borrower goes beyond a predetermined threshold, smart contracts or protocols intervene and automatically start the liquidation process. Automated systems that find and provide real-time market prices of assets, commonly known as price oracles, are arguably the most crucial tool in this process. The aim of these systems is to ensure that liquidation is based on the most recent and accurate market data available. A reliable price oracle system is essential to guarantee that the liquidation process is executed justly and efficiently.

Over-collateralization & Under-collateralization & Associated Risks

Borrowers often face the risk of liquidation due to under-collateralization, which happens when the value of the collateral provided falls below the specified threshold. It can occur unexpectedly due to market volatility or sudden changes in asset prices. In such cases, liquidation can be avoided only if borrowers have funds to pay the loan or increase collateral, which is usually not feasible.

Under-collateralization is not only risky for borrowers but also for lenders. It can lead to losses and damage the soundness of their protocols. Therefore, lenders must closely watch the value of the collateral and take appropriate steps to lessen the risks associated with under-collateralization. One such step is over-collateralization. Lending protocols typically demand collateral worth 125-150% of the desired loan amount, depending on the asset and its historical volatility. The added extra amount ensures an adequate cushion in case the value of the collateral plunges below the loan amount.

However, it is also essential to consider that liquidations also need sources since they cannot be done for free. As a result, lending platforms work closely with liquidators, incentivizing the latter to keep the system financially sound. While many lending projects sell collateral to liquidators at a discounted price, others also use extra incentives, including compensation for the risks associated with decreasing costs of collateral assets. 

Flash Loans

Flash loans, a novel financial instrument native to DeFi, have transformed the trading landscape by giving users unprecedented access to substantial capital without needing collateral. While these loans offer exciting opportunities for arbitrage, they also introduce a double-edged sword, as the absence of collateral requirements makes them susceptible to exploitation. 

Flash loans can be used to manipulate prices and artificially trigger liquidations, which can have a cascading effect on the stability of DeFi protocols. The impact of such exploits can lead to significant financial losses for both lenders and borrowers, making them a major concern for the entire DeFi industry. It is imperative to take necessary precautions to prevent these exploits and ensure the safety and stability of the DeFi ecosystem.

Final Thoughts

Liquidation is a crucial aspect that ensures the safety of the DeFi market, although some cryptocurrency users have negative opinions about it. It plays a significant role in clearing risky loans and positions, which prevents any adverse impact on asset prices and the overall state of decentralized platforms, thus promoting the safe growth of the DeFi lending market.

However, continuous innovation and vigilance are necessary. Building a resilient and trustworthy decentralized financial ecosystem requires integrating robust safeguards, adequate governance control from the crypto community's side, and possible insurance mechanisms.

As the crypto industry matures, refining liquidation mechanisms and risk management strategies will remain crucial to foster confidence among users and efficiency among lending protocols. 

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