Liquidation in Crypto: Everything You Wanted to Know about It

Dubai, UAE, 18th January 2024, Liquidation is an essential tool for maintaining balance in the unpredictable world of cryptocurrencies. It helps to eliminate dangerous loans, ensuring the safety of the crypto market and preventing significant losses. Let’s explore what liquidation is, how it operates, and the risks it carries in the crypto space.

Understanding Liquidation

Crypto owners have been presented with numerous fantastic opportunities for using their assets through DeFi, one of the most useful being the capability to lend tokens. With many lending protocols available, users’ financial options for trying various trading strategies or services expanded significantly. Although these platforms sometimes vary in crypto assets presented or loan terms, they all operate similarly: users put their assets in a smart contract as collateral to be able to borrow other crypto assets. Consequently, users can obtain capital using assets they do not need at the moment but still want to keep for longer. 

However, a significant issue arises when the value of the collateral rapidly declines. In such cases, borrowers may be tempted to run away with the loaned assets and leave behind the collateral, which is decreasing in value. Due to the regular fluctuations in the prices of coins and tokens, such temptations may occur too often. In order to strengthen themselves and maintain smooth operations, lending systems found a way to protect themselves from depreciating collaterals by liquidating them.

The process starts automatically and involves selling a borrower’s assets when their value drops below a certain threshold (also called collateral ratio). This way, lending protocols prevent loans from becoming completely under-collateralized, lowering the possibility of significant losses and default. 

Possible Risks & Solutions

Under-collateralization is a substantial risk that may firstly harm borrowers themselves. The collateral’s value can sometimes decline almost instantly, and borrowers need to have sufficient funds to be able to pay off the loan or increase the collateral. Unfortunately, many borrowers may not have the means to address this issue in a timely manner, which can result in serious financial consequences.

As mentioned above, under-collateralization is also dangerous for lenders as it may damage the stability of their protocols. Therefore, lenders need to keep a close eye on collaterals’ value and employ appropriate measures to mitigate the risks associated with under-collateralization. One of the ways to do this is through over-collateralization. Lending protocols commonly demand collateral worth 125-150% of the desired loan amount. The additional amount acts as a buffer if the collateral value drops beneath the liquidation threshold.

In addition, it is worth noting that liquidations require sources as they are not free. Consequently, lending platforms must collaborate with liquidators, motivating them to keep the system financially stable through various incentives. Those include selling the collateral to liquidators at a discounted price, compensating for the risks caused by the market volatility, etc. 

Flash Loans

Flash loans have entirely changed the trading landscape in DeFi, providing access to substantial capital without the need for collateral. Although these loans offer potent arbitrage opportunities, they have a significant drawback. The absence of collateral requirements makes these loans prone to exploitation, which can be used to manipulate prices and artificially activate liquidations, causing harm to DeFi protocols and leading to notable financial losses for borrowers. Therefore, it is crucial to create and employ safety systems to prevent these exploits and protect the safety of lending protocol users. 

Final Thoughts

Liquidation is essential for the protection of the DeFi market. It clears risky loans and positions to deter adverse impacts on asset prices, promoting safe growth. Continuous innovation and vigilance are necessary to build a resilient and trustworthy decentralized ecosystem with robust safeguards and adequate governance control. Refining liquidation mechanisms and risk management strategies will boost users’ confidence and enthusiasm, as well as the efficiency of lending protocols.

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