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in the last few months, liquidation Became the top of the news cycle in the crypto world. This article will explain what liquidations are in the context of cryptocurrencies, including how they occur and what you can do to avoid them.
A forced liquidation is the forced closure of all or part of an initial margin position by a trader or asset lender. Liquidation occurs when a trader is unable to meet his leverage allocation for his position and does not have sufficient funds to continue trading.
A leveraged position refers to using existing assets as collateral for a loan or borrowing and using the principal already pledged and borrowed money to buy financial instruments together to make a greater profit. point.
Most lending protocols such as Aave, MakerDAO and Abracadabra have liquidation functionality. According to Footprint Analytics data, there were 13 liquidation events in the DeFi market on June 18, when the price of ETH fell. On the same day, Lending Protocol liquidated him 10,208 ETH, bringing him $424 million.
A liquidation is accompanied by a liquidator. Large institutions and investors can buy the liquidated assets at a discounted price and sell them on the market for the difference.
In DeFi, stake lending is when users pledge their assets to a lending protocol in exchange for the target asset and re-invest it for more income. It is derivative in nature. In order to maintain the long-term stability of the system, the lending protocol will design a liquidation mechanism to mitigate the risks of the protocol.
let’s see manufacturerDAO.
MakerDAO supports various currencies such as ETH, USDC, and TUSD as collateral to diversify the risk of protocol assets and balance the supply and demand of DAI. MakerDAO has established a stake ratio that is 150% overcollateralized. This will determine the trigger for liquidation.
For example:
If the price of ETH is $1,500, borrowers can bet 100 ETH on the MakerDAO protocol (worth 150,000) and lend up to $99,999 in DAI at a 150% stake set by the platform. At this point, the liquidation price is $1,500.
If the price of ETH falls below $1,500, it will reach the stake rate and become vulnerable to liquidation by the platform. If liquidated, it would be equivalent to the borrower purchasing his 100 ETH for $99,999.
However, if the borrower does not want to be liquidated immediately, there are several ways to reduce liquidation risk.
In addition to setting a pledge rate of 150%, MakerDAO also sets a penalty rule of 13% for liquidations. In other words, liquidated borrowers only receive 87% of the additional assets. 3% of the fine goes to the liquidator and 10% to the platform. The purpose of this mechanism is to encourage borrowers to keep an eye on their collateral assets to avoid liquidations and penalties.
If the crypto market is thriving, high-profile heavy positions by institutions and large users are heartbreak medicine for all investors. In the current downtrend, former bull market promoters have lined up like black swans, each holding liquidable derivative assets. What’s even scarier is that the on-chain transparent system allows you to see the number of these cryptocurrencies at a glance.
A complete liquidation could not only increase selling pressure, but also trigger a chain reaction of related protocols, institutions, etc. This is because the loss gap between lending positions and collateral assets is forced to be borne by these protocols and institutions, sending them into a death spiral.
For example, when stETH fell off its anchor, CeFi institution Celsius was hit hard, exacerbating liquidity issues and causing massive runaway among users. Financial institutions were forced to sell stETH in response to user requests to redeem their assets, ultimately unable to withstand the pressure to stop account withdrawals and transfers. Similarly, Three Arrows Capital holds a large lending position in Celsius, and the difficulty of protecting Celsius itself will undoubtedly play into Three Arrows Capital’s asset stress issues until it collapses.
When the price of a currency falls and the value of assets staked by users on the platform falls below the liquidation line (mechanisms for setting liquidation vary by platform), the staked assets will be liquidated. Of course, users sell risky assets quickly to avoid liquidation during a recession.This also affects DeFi TVLsa 57% drop in TVL over the last 90 days.
If protocols cannot withstand the pressure of execution, they also face the same risks as institutions.
If a user’s assets are liquidated, they will not only lose their holdings, but will also be subject to fees or penalties charged by the platform.
Like traditional financial markets, cryptocurrency markets are similarly cyclical. Bull markets don’t last forever, and neither do bear markets. At each stage, it is important to carefully monitor assets to avoid liquidations that can lead to losses and death spirals.
In the world of cryptocurrencies, by adhering to the rules of smart contracts, shouldn’t a resilient economy look like this?
Contributors to this work are footprint analysis community July. 2022 by Vincy
Data Source: Footprint Analysis ETH Clearing Dashboard
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