Decentralized Finance (DeFi) lending protocols incorporate liquidation mechanisms to ensure loan security. These protocols generally function in two primary scenarios. The first involves Collateralized Debt Positions (CDPs), where users lock up cryptocurrency assets to mint decentralized stablecoins. This minting process effectively represents a form of borrowing. The specific minting limits and interest rates vary depending on the protocol and the type of collateral used.
The second scenario resembles a traditional money market and is categorized as lending. Here, users deposit cryptocurrency as collateral to borrow other cryptocurrencies. This process does not create new stablecoins. Each type of collateral has a unique borrowing limit, and interest rates are determined dynamically by market supply and demand.
In both models, the deposited assets act as a guarantee for the loan. If the value of this collateral falls below a required threshold, a liquidation mechanism is triggered. This process auctions off the collateral to repay the outstanding debt.
What Is the Loan-to-Value (LTV) Ratio?
Different cryptocurrencies have varying Loan-to-Value (LTV) ratios, which determine how much one can borrow against them.
For instance, on Aave, the LTV for USDT might be 75%. This means a user can borrow up to 75% of the total value of their deposited USDT. Cryptocurrencies with higher price volatility typically have lower LTVs. Aave's native token, AAVE, might have an LTV of 50%, allowing borrowing only up to half of its collateral value.
More stable assets generally qualify for higher LTVs, while highly volatile assets receive lower ratios. Many cryptocurrencies do not even meet the basic requirements to be used as collateral; protocols usually only accept well-established, large-market-cap digital assets.
Imagine a user deposits three different cryptocurrencies, each with an equivalent value of 10 ETH: DAI, LINK, and UNI. Their respective LTVs are 75%, 65%, and 40%. The total borrowing power would be calculated as follows: (10 ETH × 75%) + (10 ETH × 65%) + (10 ETH × 40%) = 18 ETH.
What Is the Liquidation Threshold?
Protocols allow users to deposit multiple asset types as collateral and borrow various assets simultaneously. Each cryptocurrency used as collateral has not only a unique LTV but also a specific liquidation threshold.
This threshold is the critical collateral value level at which the loan becomes undercollateralized and is eligible for liquidation. It is always set higher than the LTV to provide a buffer against market swings.
The Role of the Liquidator
Liquidation is performed by liquidators. This role is permissionless and open to anyone, but the field is highly competitive. Most liquidations are executed by automated bots due to the need for extreme speed.
A single liquidator can repay up to 50% of a specific debt position. In the AAVE borrowing example, a single liquidator could repay a maximum of 50% of that loan.
In return for repaying the debt, the liquidator receives the equivalent value from the borrower's collateral plus an additional incentive known as a liquidation bonus. This bonus varies per asset. Using the previous example, DAI, LINK, and UNI might have liquidation bonuses of 5%, 10%, and 15%, respectively. Generally, more stable assets offer lower bonuses, while more volatile ones offer higher rewards to compensate for the increased risk.
Understanding the Liquidation Penalty
The bonus for the liquidator comes from the borrower's collateral. This constitutes a penalty for the borrower who failed to maintain a healthy collateral ratio.
In protocols like Aave, this penalty is directly used as the liquidator's bonus. The penalty rate is predetermined and differs based on the cryptocurrency used as collateral.
What Happens When Liquidation Is Triggered?
Once liquidation begins, the outstanding debt is canceled as the liquidator repays it. The liquidator seizes an amount of collateral equal to the repaid debt plus the bonus. Any remaining collateral, if left after this process, is still returned to the original borrower. The borrowed assets also remain with the borrower. The primary loss for the borrower is the portion of collateral taken as repayment and the penalty fee.
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What Are the Risks of DeFi Liquidations?
For borrowers, the primary risk of liquidation is the loss of collateral. Additional risks include potential slippage during the auction of assets and the incurred liquidation penalty.
For the protocol itself, the risk lies in insufficient market liquidity. If there isn't enough market depth to sell the collateral liquidated, the process may not be completed fully, potentially leaving the protocol with bad debt.
To mitigate these liquidity and bad debt risks, some lending protocols have implemented innovative mechanisms. These include establishing dedicated risk funds or using their own treasury assets to perform instant liquidations, thereby avoiding reliance on immediate market liquidity.
Frequently Asked Questions
What is a healthy collateral ratio in DeFi lending?
A healthy collateral ratio is significantly above the protocol's liquidation threshold for your specific assets. It's a buffer that protects you from sudden market drops triggering liquidation. Regularly monitor your positions, especially during periods of high volatility.
How can I avoid being liquidated?
You can avoid liquidation by depositing more collateral to increase your ratio, repaying a portion of your borrowed assets, or using more stable coins as collateral. Setting up price alerts for your collateral assets can also provide an early warning.
Is being a liquidator profitable?
It can be, but it is highly competitive. Profitability depends on the size of the liquidation bonus, gas fees for transactions, and the ability to act faster than others, which almost always requires using automated bots and sophisticated monitoring tools.
What's the difference between LTV and the liquidation threshold?
The Loan-to-Value (LTV) ratio determines your maximum borrowing power. The liquidation threshold is the collateral value level at which your position becomes eligible for liquidation. The threshold is always higher than the LTV, creating a safety cushion.
Do all DeFi lending protocols have the same liquidation rules?
No, rules can vary significantly between different protocols like Aave, Compound, and MakerDAO. It is crucial to read and understand the specific parameters, including LTVs, thresholds, and bonuses, for each platform and asset before depositing funds.
Can I lose all my collateral in a liquidation?
Not necessarily. A liquidator typically only repays a portion of the debt (e.g., up to 50%) in one transaction, taking a corresponding portion of your collateral plus a bonus. However, if the market continues to drop, your position could be liquidated multiple times until the debt is fully covered or you add more collateral.