DeFi, like loan protocols, is a new and interesting option for people who do not really want to keep funds in the bank. As investors, we get access to an entirely new way of borrowing. At the same time, we can earn more from our cryptocurrencies. However, this carries a certain risk, more precisely – liquidations.
What are they, how do they work in the DeFi ecosystem and how to manage risk in such a situation – this is what we will deal with today.
Definition of DeFi and a reminder of how it works
Decentralized finance (DeFi) are financial applications, built on blockchain technology. They allow users to make transactions without intermediaries (banks or other financial institutions). Arrangement (transaction) is done via smart contracts.
DeFi projects include:
DEX’y, that is decentralized cryptocurrency exchanges. They allow transactions to be made directly between user A and B. The most popular DEX is UNISWAP.
Different kinds of lending platforms that enable users to take out loans. This group includes Aave, Compound and Maker.
Loan ecosystems, synthetic assets. This group includes Synthetics and Fulcrum.
Oracles responsible for transmitting information from the outside world to the ecosystem blockchain. They are essential for the operation of any protocol DeFi. A leader, as I’m sure you know, is Chainlink. We wrote more about it here.
Stablecoins worth mentioning. At the same time, you must remember that they are on the verge of DeFi. Stablecoins are the so-called stable cryptocurrencies that reflect the value of a given fiat currency – USDT, BUSD or DAI.
You are a diligent student, so from our previous lessons you know how the protocols work in decentralized finance. Nevertheless, to understand what liquidations are, we will briefly recall the basic assumptions of loans in DeFi.
As a borrower, you list yours cryptocurrencies as collateral for the loan. Given the volatility of digital assets, your collateral can also change in value. Then, the chance that the loan will be liquidated, and you will lose your collateral is much, much higher.
This is how liquidations work, DeFi. This carries a massive risk for the borrower. So, it’s worth knowing how to use lending protocols wisely in the decentralized finance space.
The problem of liquidation and loans – explanation
Assumption loans are simple. You need a certain amount of money to give back later. In addition, you pay interest to the person who lent it to you – you give him collateral. It provides the lender with a way to recover your funds when you are unable to make repayments. Using collateral against your debts is called Liquidation.
Liquidations in DeFi are a similar process. Then the smart contract sells your cryptocurrency collateral to cover your debt. However, they are more insidious than loans in traditional finance. Why?
As we mentioned – for volatility, cryptocurrency values. The collateral you provide may change overnight and be useless to cover your losses. Which is why smart contracts that govern loan protocols contain an additional condition. Example:
We take out a loan in DeFi. We give X bitcoins as collateral. If the value of our BTC collateral falls below the liquidation threshold, the protocol will automatically liquidate our loan by selling our collateral. It doesn’t matter that, for example, we have repaid most of it. The protocol will want to recoup its costs before the value of bitcoins drops even more and can’t cover our debt.
The same process occurs in the case of Ethereum or other cryptocurrencies.
Whim of the market? Some. Taking a loan in DeFi, you must bear in mind that your security may not return. It doesn’t matter how much of the loan you have repaid.
It is also not that loan protocols transfer all responsibility to the borrower. Furthermore, it’s also a risk for them. If the loan is liquidated, the protocol is left with collateral that no one will want to buy. Thus, the protocol will not recover the loan. Therefore, to make a quick sale, smart contracts sell our collateral discounted.
Liquidation risk – can we avoid it?
Considering the volatility of the value, cryptocurrencies, so will our security. We have to use common sense between security and quantity of cryptocurrencies that we borrow. You can always increase the value of the deposit you deposit.
DeFi is an ecosystem with its own rules and risks. Before you start navigating it in the protocol, understand how it works and how they work smart contracts. Education above all. We have already discussed this topic in our lessons.
Trivia
- Liquidation is often associated with stop loss for borrowers
- The liquidation threshold protects the lender from falling prices.
- DeFi platforms offer liquidation bonuses for liquidators.
- Liquidators deal with the purchase of discounted collateral and cover the debt on the account.
- Liquidators often work with bots to liquidate loans even faster and earn bonuses.
Summary
Another step forward! You already know what they are liquidations in DeFi – congratulations. We invite you to follow the next lessons in our series.