DeFi Liquidation Explained

Borrowing in DeFi opens new options for the unbanked – not to mention the chance for investors to leverage their position and maximize their gains – but it also carries unique risk. Here, we explain DeFi liquidation, how it works and what risks it poses to you and the industry more broadly.

Although lending and borrowing is an age old part of finance, in the crypto environment there are some unique challenges involved, and with them, some big consequences. In this article, we’re exploring one of the key risks to your collateral if you’re using a borrowing protocol in the DeFi space.

First, the Basics: What Exactly Is Liquidation?

Providing collateral is an age-old norm for borrowers looking to take out a loan. For example, you might use your property as collateral in order to take out a significant loan. Doing so gives the lending institution a sure-fire way of recuperating their money from you, even if you can’t make your repayments. In theory, your house will always be worth at least as much as the loan.

But this guarantee is only effective as long as the collateral itself maintains a steady value – if the price of your house suddenly crashed, for example, the lender wouldn’t have security anymore. Luckily, assets used for collateral normally maintain a steady enough price for this not to be an issue – but in crypto, it’s a different story.

Why Your Crypto Collateral is at Risk

In DeFi, taking out a loan means providing crypto collateral – but the value of cryptocurrency is volatile. The value of the Ethereum or NFTs you used as collateral last week might have completely changed this week and if the collateral itself falls in value, it’s no longer useful to the DeFi lender as a guarantee. To be clear, this problem exists in the traditional finance space aswell – any asset can change in value. But the issue is far more common, and far more pronounced, in DeFi, because the value of crypto is so inconsistent.

So for borrowers, DeFi might represent huge freedom, less red tape and new opportunities for borrowing – but it also presents a higher level of risk when it comes to their crypto collateral. And it’s you, the borrower, who bears that risk.

DeFi Liquidation: An Example

Say you’ve taken out a loan on a lending protocol,and you gave your valuable NFT as collateral – the collection is performing well, and the value of your NFT is fare greater than the amount you’re borrowing. The risks seem low.

But if the market value of that NFT goes below a certain point (something called the liquidation threshold) the protocol will automatically liquidate your loan, auctioning off your NFT for far less than its value.

You just lost your NFT – or whatever collateral you were using – without any opportunity to simply pay back the loan. And it’s not because you couldn’t repay, but because the market decided your collateral was worth less.

In DeFi, you, the lender, are at the mercy of the market.

No matter how much of your loan you’ve paid off, there is always a chance that precious collateral isn’t coming back, and this is all do due to price volatility.

DeFi Risks for Lenders

And what about the lenders?

It might seem like DeFi puts all the risk onto the borrower, but the volatility of crypto means a bigger risk for lending protocols too. It’s not ideal for a lending protocol to be left with collateral assets to sell – there’s always a risk that nobody will want to buy those assets, leaving the protocol unable (still) to recoup their loan. 

To get around this, protocols will auction off liquidated assets at less than their value – in DeFi, allowing third parties to “bid” on the assets for a quick sale. This “race to the bottom” negatively impacts the value of the entire currency or collection.

So in short, the way liquidation is managed in DeFi is not only risky for borrowers like you and me, but has an impact across the board, on lenders and currencies generally. This unique marketplace is something that needs to be borne in mind if you’re seeking to borrow yourself.

Can You Avoid Liquidation Risk (As a Borrower)?

If the collateral is volatile (which is the case in crypto), you should maintain a healthy margin between yur collateral and the asset you’re borrowing. If the market starts moving, you can also raise your collateral value by depositing more collateral assets or start repaying the loan to avoid liquidation.

DeFi is an ecosystem with its own rules and risks, and while you can’t change those, you can arm yourself to navigate the space safely, by learning how it works. Understanding how to read a smart contract is a great start, because it will allow you to investigate protocols you’re interacting with, and their conditions. 

Similarly, making sure you use a wallet that gives maximum transparency as you engage with those smart contracts will enable you to understand what you’re agreeing to each time you interact.

Knowledge is an Advantage

While there are risks involved, lending protocols offer both lenders and borrowers advantages, not least, access to financial services that might not have been available in the traditional system.

Knowing the risks involved is one of the first steps in mitigating them. At Ledger, we know there’s a whole lot of power in knowledge and we’re here to make sure you step into the digital space with as much insight as possible. See you next time, fren!

Knowledge is Power.

Trying to make your way in crypto – but not sure where to start? Here, we don’t tell you how to get rich, but we do tell you a few facts that might help you navigate the space. Thanks, School of Block!