One of the key innovations of DeFi is the ability to take out overcollateralized loans using your crypto as collateral. However, this also introduces the risk of liquidation if the value of your collateral drops below a certain threshold.

In this article, we’ll dive deep into DeFi liquidations - understanding what they are, why they happen, the mechanics behind liquidations, as well as tools and strategies you can use to monitor liquidations across protocols. With a solid grasp of liquidations, you’ll be better equipped to manage risk as a DeFi user.

What is a DeFi Liquidation?

A DeFi liquidation refers to the forcible closure of an undercollateralized loan position. Essentially, it’s when a lending protocol automatically seizes the borrower’s collateral and sells it off to repay the outstanding loan.

Let’s break this down...

When you take out a loan from a DeFi protocol, you need to put up more value in collateral than the loan amount. For example, you might put up $150 worth of ETH to take out a $100 stablecoin loan. This extra buffer protects the lenders’ capital in case the assets decline in value.

Most DeFi loans require the borrower to maintain a minimum collateral ratio, say 150%. If the value of collateral dips below that level, it risks there not being enough collateral to repay the loan.

So if ETH prices crashed, causing your $150 in ETH collateral to fall to $90 in value - less than the $100 loan amount - it risks the lenders losing money on that loan.

To mitigate that risk, DeFi protocols have automated “liquidation engines” that kick in if a position falls too far below the minimum collateral requirement. These liquidation engines seize the borrower’s collateral assets, sells them off to the market, and uses the proceeds to repay as much of the outstanding borrower’s debt as possible. Any excess value left over goes back to the borrower.

Key Drivers of Liquidations

1. Volatility: DeFi loans are highly sensitive to volatility as collateral values fluctuate. A sudden crash in the value of coins used as collateral is the #1 cause of liquidations across protocols.

2. Liquidation Ratios: Each lending protocol sets a liquidation ratio threshold, generally 100-150%. If collateralization dips below this, liquidation kicks in. Lower ratios = higher liquidation risk

3. Price Oracles: DeFi lending protocols rely on price oracles to track asset prices. Any glitches here can cause inaccurate collateral valuations, triggering unnecessary liquidations

Why Do Liquidations Matter?

Liquidations have emerged as a pain point for borrowers, while also creating opportunities for “liquidators” who can profit by participating in these liquidation events.

For borrowers, liquidations can mean losing your valuable crypto assets. Even a temporary price crash could wipe out collateral before prices recover again.

For lenders and the overall health of lending protocols, efficient liquidations are critical to maintain the solvency of the platforms and ensure lenders don’t lose out on principal and interest payments.

However, liquidations aren’t inherently bad. When designed well, they act as a safeguard to maintain system solvency and align incentive between borrowers and lenders. The key is understanding liquidation mechanics deeply enough to avoid unnecessary liquidations.

DeFi Lending Protocols

Now let’s explore some lending protocols and their liquidation mechanisms:

Aave

When borrowers open a loan on Aave, they need to maintain a minimum collateral ratio of 100-83%, based on the riskiness of assets used as collateral. This means if your collateral value declines by 17-25% from its value at time of borrowing, liquidation kicks in.

The Aave liquidation engine tries to sell the collateral at a 12.5% discount to market price, to encourage liquidators to quickly repay the borrowers’ debt. Any excess collateral gets returned to the borrower, minus a penalty fee.

Compound

On Compound, the liquidation ratio depends on the specific crypto asset used as collateral, ranging from 50% to 75%. Due to volatility, assets like BTC tend to have conservative ratios near 50%, while stablecoins can sustain higher ratios.

Compound’s liquidation engine sells collateral at a 5% discount to Compound Oracle prices to attract liquidators. So collateral is not sold directly on the open market.

MakerDAO

One of the most complex liquidation mechanisms is the Maker protocol and its DAI stablecoin which has its own unique system to maintain its $1 peg.

When users lock up crypto as collateral to open a collateralized debt position (CDP) backing DAI stablecoins, the minimum ratio is 150%. Falling below that triggers a liquidation auction for the collateral assets.

There’s a two-part auction process: First a fixed discount auction open only to Maker keepers, followed by an English auction open to all. The two auctions are designed to simplify liquidation while maximizing returns.

Margin Trading Protocols

Liquidations work differently on DEX margin trading platforms like dYdX and GMX, where traders borrow funds to leverage their positions. These work on a "socialized loss" model - if an undercollateralized position gets liquidated, a portion of losses are shared among all platform lenders to cushion the blow.

Additionally, margin trading liquidations happen much quicker with more volatile price swings in futures markets. Borrowers need to closely monitor markets to avoid quick liquidations.

Market Liquidations vs Protocol Liquidations

There are two core types of liquidations:

Market Liquidations

Triggered by DeFi protocols when collateral ratios fall below a minimum threshold. Protocol smart contracts initiate and coordinate the liquidation.

Undercollateralized positions are hit first when there’s a market crash since collateral values directly impact the liquidation ratio.

Protocol Liquidations

Some protocols have governance tokens that confer voting rights. If a majority of governance token holders vote to liquidate a position, that results in a protocol liquidation.

For example, MarkerDAO governance token holders voted to liquidate undercollateralized DAI stablecoin positions around March 12, 2020 (‘Black Thursday’ crash) to protect the broader protocol.

Monitor DeFi Liquidations

Now let’s explore ways DeFi participants can monitor liquidations across protocols to manage risks:

1. On-Chain Analytics

On-chain data provides the most reliable source to analyze real-time liquidation data across protocols.

Analytics tools like Dune Analytics contain dashboards tracking lending activity across Compound, Aave, and more. Filter by liquidation events to analyze historical or live data.

2. Liquidation Bots & Trackers

Liquidity bots can alert you instantly when a position falls near liquidation level. This gives borrowers precious minutes to decide - add collateral, repay part of debt, or exit position entirely.

DeFi watchers can similarly set up trackers to monitor industry-wise liquidations. On days with market volatility, keeping an eye on overall liquidations conveys how protocols are standing up.

3. Community Discussions

Given the nascency of DeFi, joining community forums like Discord groups can provide qualitative insights into how protocols perform around liquidations. Live feedback from user experiences supplements on-chain data.

4. Whitepapers & Documentation

While dry, reading through the technical specifications around liquidations in protocol documentation equips you to deeply understand risks. The devil lies in details around oracle mechanisms, auction models, penalty calculations, etc.

5. Stress-Testing Liquidations

Analytical borrowers should conduct backtests or simulations to estimate liquidation risks under different scenarios - how historical volatility episodes impact collateral values based on liquidation ratios. This can inform position sizing and collateral ratios.

Mitigating Liquidation Risks

Enhance understanding of liquidations is moot unless we apply those insights to avoid unnecessary liquidations. Here are 5 tips:

1. Select Collateral Wisely

The crypto asset used to collateralize a loan significantly influences liquidation risks. As a rule, choose stablecoins and tokens with historically lower volatility.

2. Maintain Conservative Ratios

Don’t push collateral ratios to their limits. Build in a buffer so your position can withstand some volatility without getting liquidated.

3. Use Risk Frameworks

Before opening positions, have clear risk management frameworks in place spelling out actions if collateral values dip by 10%, 20%, etc. Respect those rules.

4. Monitor Positions Closely

Choose liquidation notification tools that align with your risk tolerance, whether that’s 24/7 monitoring or occasional check-ins during volatile periods.

5. Don't Rely on Oracles

Don’t expect oracles to always reflect most current prices during flash crashes or volatility. Have backup plans in case prices move quicker. Assume some slippage from DeFi oracles relative to the market.

Opportunities for Liquidators

Liquidations don’t just endanger borrowers. They create opportunities for profit.

When undercollateralized positions get liquidated, you can participate in the auction process to purchase assets seized by protocols at a discount to market prices. If you successfully repay some portion of outstanding borrower debt, you get to pocket the assets you purchased at a discount.

Wrapping Up

As DeFi lending continues growth exponentially, crypto liquidations are bound to pile up during this market’s volatility epochs. However, armed with the right mental frameworks around liquidation mechanics across major protocols, both borrowers and liquidators can develop strategies to boost gains and mitigate risks tied to liquidations events.

If you enjoyed this article, please read my previous articles

How do newbies participate in DeFi projects?
The Basics of Yield Farming: How to Earn Passive Income in DeFi
Four elements of DeFi value discovery
Decentralized Liquidations: Critical Knowledge for DeFi Borrowers
What are the risks in DeFi opportunities?
The Power of Automated Market Makers in DeFi
Asset Management in DeFi

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