What You Need to Know Crypto Liquidations and How to Avoid Them (2024)

Treehouse

Published in

Coinmonks

8 min read

Mar 31, 2023

Liquidation in DeFi Lending and Borrowing

One of the main differences that sets DeFi apart from traditional finance (TradFi) systems is the democratization of financial services. DeFi has no know-your-customer (KYC) or credit score systems to determine whether users can borrow funds. This is countered by overcollateralized loans. Lending and borrowing protocols, such as Aave and Compound Finance, are among the most used services in the DeFi space.

What You Need to Know Crypto Liquidations and How to Avoid Them (4)

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Undercollateralized lending is a sector in DeFi, but we will only focus on overcollateralized lending for this article. Learn more about undercollateralized loans in our Insights piece here!

How Does Liquidation Happen With Overcollateralized Lending?

For overcollateralized lending, borrowers have to deposit a set amount of crypto worth more in value than the amount they are borrowing. Collateralization rates or factors, referring to the ratio of the collateral to borrowed amount, may vary between protocols. Instead of liquidation by a centralized entity, as in the case of TradFi systems, DeFi smart contracts automatically sell borrowers’ collateralized assets to cover debt when the borrow balance exceeds the limit set by the collateralization factor. Protocols offer liquidation bonuses by selling borrowers’ collateral at discounted prices to liquidators, using the proceeds to repay borrowers’ debts.

However, this sometimes leads to gas wars between liquidators competing for discounted collateral assets. In these situations, maximal extractable value (MEV) could affect and decide who receives the rewards.

An Example of Liquidation From DeFi Borrowing

Here is a simple example of how liquidation occurs. Assuming that token XXX is worth US$2 and the collateral factor is 50%:

A collateral of 50% means that Bob can borrow up to 50% of the value of his deposit.
Using Protocol X, Bob borrows 100 USDC, worth US$100, with collateral of 100 XXX, worth US$200.
XXX’s price suddenly drops from US$2 to US$1.
Bob would be borrowing 100 USDC with collateral valued at only US$100, no longer fulfilling the 50% collateral factor.
Protocol X liquidates Bob’s collateral of 100 XXX, offering other users a chance to buy XXX at US$0.80 instead of US$1.

It is important to note that the above is a brief outline of what happens during liquidation on DeFi lending protocols. Each protocol has its own unique mechanism, and you should always do your own research (DYOR) and understand the risks involved before participating in the protocol.

Liquidation in Crypto Margin Trading

Similar to TradFi markets, margin trading is a financial instrument that is commonly used by DeFi users to increase the size of their positions and buying power through leverage. While this allows users to increase their earning potential, it also increases their risk of loss by the same multiplier applied through leverage. Crypto leveraged trading is available on centralized exchanges (CEXs), such as Binance and Bybit, and decentralized exchanges (DEXs), such as GMX and dYdX.

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Crypto margin trading platforms require users to deposit collateral as an initial margin before opening a leveraged position. Users will face a margin call if the asset price drops and causes the collateral value to fall below the liquidation threshold. If they cannot put up more margin to maintain the position, a forced liquidation will happen, and the platform will close the position automatically. Often, exchanges also impose a liquidation fees to encourage users to close their positions before they are liquidated, also known as voluntary liquidation. Different platforms or protocols may differ in their liquidation thresholds and trading mechanisms, so it is important to understand how they work before using them.

An Example of Liquidation From Crypto Margin Trading

Assuming that token XXX is worth US$2, Bob opens a margin trading position with X Exchange with an initial margin of US$2,000 worth of 1,000 XXX and 5× leverage.

Bob borrows 4,000 XXX from X Exchange to increase his position from 1,000 to 5,000 XXX, worth a total of US$10,000 initially.
The price of XXX drops by 20% from US$2 to US$1.60 and Bob loses US$2,000, equivalent to his initial margin, indicating a 100% loss.
If the price of XXX drops more, the loss will “eat into” his borrowed funds.
X Exchange closes and liquidates Bob’s position to prevent further losses involving his borrowed capital.
Bob loses his margin trade position and initial capital of US$2,000.

Several parties are involved in crypto liquidations, whether for DeFi lending and borrowing or crypto margin trading.

Lenders

DeFi lenders provide liquidity to a pool to earn interest. Compared to TradFi markets, DeFi protocols generally offer higher interest rates and rewards. Liquidation mechanisms in lending protocols use liquidators to ensure that lenders will not lose their assets.

Borrowers

For borrowers, lending protocols necessitate collateralization of assets prior to lending. If the value of their collateral drops, borrowers either have to top it up, or the platforms or smart contracts will automatically liquidate their collateral. In the case of margin trading, users will receive a margin call, and their positions will be closed.

Liquidators

For DeFi lending and borrowing, liquidators are users that play a key role in maintaining the solvency of the lending and borrowing protocol by paying off the debts of liquidated borrowers. Lending protocols incentivize these liquidators with liquidation bonuses by selling the collateral at a significant discount. Due to the competition to purchase discounted crypto, many liquidators make use of bots to help them in “winning” the transactions. In the case of margin trading, the platforms and exchanges assume the role of liquidators.

What Happens if the Borrower Is an Institution?

If the borrower is an institution, more stakeholders will be impacted by a liquidation, such as the company’s directors, employees, and shareholders, as well as the organization’s customers or clients. Institutions often borrow from multiple sources, so they might face several liquidations by different creditors concurrently.

Further, depending on the jurisdiction in which the institution is located, restitution regulatory authorities may also be involved in the liquidation process to ensure that it is carried out in accordance with the relevant laws and regulations.

Liquidation is a primary risk for crypto traders, especially with the volatile nature of crypto assets. However, this risk can be mitigated by establishing risk appetites and employing relevant risk management strategies in regular and margin trades.

Risk Management Strategies

Stop Loss Orders

A stop loss is a pre-placed order that automatically closes a long or short position when the price moves in a direction that differs from the trader’s expectations. Traders can consider three types of stop loss orders in their risk management strategy.

Buy/Sell Stop Orders
Buy/sell stop orders are the most basic type of stop loss orders.
Buy Stop: Closes a short position, triggered when the price rises above a specified level
Sell Stop: Closes a long position, triggered when the price falls below a specified level
Trailing Stop Loss Orders
Trailing stop loss orders are dynamic stop orders that allow traders to set a maximum amount of loss in terms of a percentage or a fixed amount rather than setting a fixed stop price level. This means that the stop price moves along with the asset’s price and is a strategy more suited for volatile crypto assets.
Stop-Limit Orders
A stop-limit order combines a stop and a limit order. The order will be stopped once the price becomes unfavorable based on the trader’s specified limit and timeframe. This gives traders greater control over the precision of when they want their orders to be filled. After the stop price is triggered, the limit order takes effect to ensure that the order is completed only at a price equal to or better than the set limit price. This strategy is particularly useful for hedging against sudden price spikes for volatile assets such as cryptocurrencies…

Enjoyed reading this? Read the full piece here to learn more risk management strategies to prevent facing crypto liquidations.

Disclaimer

This publication is provided for informational and entertainment purposes only. Nothing contained in this publication constitutes financial advice, trading advice, or any other advice, nor does it constitute an offer to buy or sell securities or any other assets or participate in any particular trading strategy. This publication does not take into account your personal investment objectives, financial situation, or needs. Treehouse does not warrant that the information provided in this publication is up to date or accurate.

Treehouse APIs provide you with DeFi analytics through comprehensive current and historical data for your DeFi portfolios to meet your monitoring, trading, and reporting needs. Contact us if you are interested, or check out our integration with CryptoSheets! Otherwise, visit Treehouse Academy, Insights, and Treehouse Daily for in-depth research.

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