What are crypto liquidations and why do they matter?

In the last several months, liquidations have become top of the news cycle in the crypto world. This article will explain what liquidations are in the context of crypto, including how they happen and what you can do to avoid them.

What is a Crypto Liquidation?

A liquidation is the forced closing out of all or part of the initial margin position by a trader or asset lender. Liquidation occurs when a trader is unable to meet the allocation of a leveraged position and does not have enough funds to keep the trade operating.

A leveraged position refers to using your existing assets as collateral for a loan or borrowing money and then using the principal already pledged and the borrowed money to buy financial products together to make a bigger profit.

Most lending protocols, such as Aave, MakerDAO, and Abracadabra, have a liquidation function. According to Footprint Analytics data, on June 18, when the price of ETH fell, there were 13 liquidation events in the DeFi market. On the same day, lending protocols liquidated 10,208 ETH, with a liquidation amount of $424 million.

With liquidations come liquidators. Large institutions or investors may buy the liquidated assets at a discounted price and sell them in the market to earn the difference.

Why Do Crypto Liquidations Happen?

In DeFi, stake lending is when users pledge their assets to the lending protocol in exchange for the target asset and then invest again for a second time to earn more income. It is essentially a derivative. In order to maintain the long-term stability of the system, the lending protocol will design a liquidation mechanism to reduce the risk for the protocol.

Let’s take a look at MakerDAO.

MakerDAO supports a variety of currencies such as ETH, USDC and TUSD as collateral in order to diversify the risk of the protocol assets and adjust the supply and demand of DAI. MakerDAO has established a stake rate, which is over-collateralization, of 150%. This determines the trigger for a liquidation.

Here’s an example:

When the price of ETH is $1,500, a borrower stakes 100 ETH to the MakerDAO protocol (valued at 150,000) and can lend up to $99,999 DAI at the 150% stake rate set by the platform. At this point, the liquidation price is $1,500.

If the price of ETH falls below $1,500, ETH will hit the stake rate and will be vulnerable to liquidation by the platform. If it is liquidated, it is equivalent to a borrower buying 100 ETH for $99,999.

However, if the borrower does not want to be liquidated quickly, there are several ways to reduce the risk of liquidation.

• Lend less than $99,999 DAI
• Return lent DAI and fees before the liquidation trigger
• Continue to stake more ETH before liquidation is triggered, reducing the stake rate

In addition to setting a 150% pledge rate, MakerDAO also sets a 13% penalty rule for liquidation. In other words, borrowers who have been liquidated will only receive 87% of their top-up assets. 3% of the fine will go to the liquidator and 10% to the platform. The purpose of this mechanism is to encourage borrowers to keep an eye on their collateral assets to avoid liquidation and penalties.

How do Liquidations Impact the Market?

When the crypto market is prosperous, high-profile and heavy positions by institutions and large-scale users are the ”reassuring pills” for all investors. In the current downtrend, the former bull market promoters have become black swans lining up, each holding derivative assets that can be liquidated. What’s even scarier is that in a transparent system on-chain, the numbers of these crypto assets can be seen at a glance.

For institutions

Once it suffers a complete liquidation, it could trigger a chain reaction of related protocols, institutions and others, in addition to bringing more selling pressure. This is because the loss gap between the lending position and the collateralized assets will be forced to be borne by these protocols and institutions, which will put them in a death spiral.

For example, when stETH went off-anchor, CeFi institution Celsius was greatly affected, exacerbating liquidity problems and causing a massive run on users. The institution was forced to sell stETH in response to the demand from users to redeem their assets, and was eventually unable to withstand the pressure to suspend account withdrawals and transfers. In turn, Three Arrows Capital holds a large lending position in Celsius, and Celsius’ difficulty in protecting itself will definitely affect Three Arrows Capital’s asset stress problem until they collapse.

For DeFi protocols

When the price of the currency falls and the value of the assets staked by users in the platform falls below the liquidation line (the mechanism for setting up liquidation will vary from platform to platform), the staked assets will be liquidated. Of course, users will sell risky assets quickly to avoid liquidation in a downturn. This also affects DeFi’s TVL, which has seen TVL fall 57% over the past 90 days.

If the protocol cannot withstand the pressure of a run, it will also face the same risks as the institution.

For users

When a user’s assets are liquidated, in addition to losing their holdings, they are also subject to fees or penalties charged by the platform.

Summary

As with traditional financial markets, cryptocurrency markets are equally cyclical. Bull markets don’t last forever, and neither do bear markets. At each stage, it is important to be cautious and watch your assets closely to avoid liquidation, which could lead to losses and a death spiral.

In the crypto world, abiding by the rules of smart contracts, shouldn’t a resilient economy be like this?

This piece is contributed by Footprint Analytics community in July. 2022 by Vincy

Data Source: Footprint Analytics – ETH Liquidation Dashboard

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