Liquidation in the context of decentralized finance (DeFi) refers to the process of selling or closing a position when the value of the collateral falls below a specific level. This can occur with DeFi loans, margin trading, or other financial instruments that involve collateral. Here’s how it generally works, what can trigger a liquidation event, and ways to avoid it.
How DeFi Liquidation Works:
- Opening a Position: When you take out a loan or trade on margin in a DeFi protocol, you’re often required to provide collateral, such as Ether (ETH), to secure the borrowed funds or leveraged position.
- Monitoring Collateral Value: The DeFi platform monitors the value of the collateral in relation to the borrowed amount or position size. This ratio is often referred to as the Loan-to-Value (LTV) ratio.
- Liquidation Threshold: A liquidation threshold is set, such as an LTV ratio of 75%. If the value of the collateral falls and reaches this threshold, a liquidation event is triggered.
- Liquidation Process: Once triggered, the DeFi platform may automatically sell the collateral at a discount, or other users (called liquidators) may purchase it through the protocol. Liquidators might receive a reward or incentive for performing the liquidation.
- Covering the Debt: The proceeds from the sale are used to cover the outstanding debt or position, with any remaining funds returned to the borrower (if applicable).
What Triggers a Liquidation Event:
- Price Fluctuations: A significant decline in the value of the collateralized asset (e.g., a sharp drop in ETH price) can cause the LTV ratio to reach the liquidation threshold.
- Market Volatility: Sudden and extreme market movements can cause rapid changes in asset prices, leading to liquidation.
- Smart Contract Risks: Errors or vulnerabilities in smart contracts could lead to unforeseen liquidation events.
How to Avoid DeFi Liquidation:
- Maintain a Healthy Margin: Keeping the LTV ratio well below the liquidation threshold provides a buffer against market fluctuations.
- Monitor the Market: Regularly check the value of the collateral and the state of the broader market to anticipate potential risks.
- Use Stable Assets: Collateralizing with stablecoins or less volatile assets can reduce the likelihood of liquidation.
- Consider Insurance: Some DeFi protocols offer insurance options to protect against liquidation.
- Stay Informed About the Platform: Understanding the specific liquidation rules of the DeFi protocol you are using is essential to managing risks appropriately.
Liquidation in DeFi is a complex process with its unique risks and considerations. Awareness, diligent management of collateral, and understanding the specifics of the platform can help in avoiding unfortunate liquidation events. Always consult with a financial advisor or do thorough research when engaging in DeFi activities, as the risks and regulations can vary widely across different platforms and jurisdictions.
Last week we saw a dramatic liquidation even due to the price of Bitcoin dropping dramatically in a short period which led to over 800 million dollars worth of crypto to be liquidated. Read more here.