06 Jan 2023
Risk and Reward of Crypto On Chain Liquidations
Liquidations refer to a leveraged position being wound down due to the risk of impending insolvency. When this occurs, the assets a borrower/trader posted to guarantee repayment are either wholly or partially seized.
Liquidations are the most popular concept in the crypto industry. With crypto’s extreme volatility comes lucrative opportunities. Liquidations refer to the process of a leveraged position being shut down because of impending insolvency. When someone is liquidated, the collateral to guarantee repayment is seized by a third party. Users who have traded crypto derivatives or taken loans from DeFi money markets will be familiar with the concept of liquidations. Almost every crypto trader has been hit with one of these email chains. (Warning might trigger PTSD)
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Derivative-based liquidations are the most important in this space, but in this deep dive, we will focus on on-chain liquidations and where to look. In the wild west of DeFi, degenerates look to increase their exposure through leverage. They do this to make it all back in 1 trade (the last time they did this, they lost it all). In the early days of DeFi, degenerates could not slide the leverage bar to the right, so they had to do it the old-fashioned way. They took over-collateralized loans from popular money markets like Aave and Compound to increase exposure.
This act, however, does not come without risks. If the value of a borrower’s collateral decreases against the borrowed asset, the borrower’s collateral assets are subject to liquidation.
A suitable liquidation mechanism is essential for trustworthy money markets and should help protocols weather periods of market volatility and illiquidity.
The most straightforward type of liquidation mechanism is the fixed discount liquidation that Aave and Compound use. In a fixed discount liquidation, loans within the liquidation threshold can be instantly liquidated at a predetermined discount. This liquidation discount depends on the asset used as collateral, and more volatile assets require a higher liquidation discount.
Aave, for example, allows liquidators to purchase up to 50% of an underwater position. Depending on the collateral, liquidators can purchase this for a 15 % discount. A liquidator must have a sufficient balance of the debt asset before initiating the liquidation call to purchase the capital at a discount. Liquidators then engage in priority gas auctions to determine who can liquidate the loan position.
Make used to use an English auction as its engine. This is where potential liquidators submit bids of increasing value for a position. Bidders would raise that bid by offering more DAI until it covered the outstanding debt. If sufficient DAI was offered to cover the debt in the English auction, it is followed by a reverse auction. If not, the collateral auction ends after the English auction; the winning bidder is awarded the collateral, and the protocol incurs bad debt. Maker decided to stop using the English auction because it gives up zero-bid auctions. Zero-bid auctions are where some collateral auctions are won by liquidators placing zero.
In response to the shortcomings of their previous liquidation mechanism, Maker implemented Liquidations 2.0 in May 2021. Since then, the liquidation process has been streamlined into a single Dutch auction. Here the collateral is priced at a high initial bid that decreases deterministically over time until a willing buyer is found. If there is no willing buyer, the discount on the collateral increases up to a predetermined limit or until the maximum auction duration is reached.
Therefore, potential liquidators must decide whether to jump in at the current offer or wait for the discount to increase. If the choice is the latter, the would-be liquidator risks giving it to another liquidator willing to accept a smaller discount. Liquidators will thus choose to liquidate when it is sufficiently profitable for them to take the bid.
This is an orderbook of bids for purchasing liquidated collateral. Before Anchor protocol broke, it used to use this liquidation engine. Users that would like to participate in the liquidations on Anchor may place UST bids at a liquidation discount of their choice between 1-30%, in 1% intervals. The lower the discount, the higher it is placed on the queue. During a liquidation event, the collateral is sold into those bids from the highest to the lowest.
Liquidation mechanisms have existed mainly in DeFi as an insignificant feature of money markets. Often overlooked are the variations that have emerged and improvements that have taken place over the last few years. During periods of market volatility, these liquidation mechanisms take center stage and prove their merit. Volatility events are the perfect stress test for liquidations.
Ethereum has been trading at $1200 for the last two months. Looking at the image above, we see many liquidations below $1000. It starts at about $950 and goes to about $250. The most significant liquidation at $750 will be hit. At $750, there is over 200k ETH waiting to be liquidated. Once it is hit, we will stress test all DeFi lending platforms. At this point, we will see if DeFi is ready for real-world use. If systems decide to fail at $750, I see no reason why we will not cascade down to $500 or even $200. I know I will buy all your ETH if we see these prices.
Disclaimer: Nothing on this site should be construed as a financial investment recommendation. It’s important to understand that investing is a high-risk activity. Investments expose money to potential loss.