What is a Liquidation?
Both the DeFi and crypto markets have been known for their significant price volatility. During major price drawdowns like in March 2020 and May 2021, this volatility has triggered cascading liquidations among traders, but what does the word liquidation mean? This article will explain what a DeFi liquidation is, give an example of how it works, and finally how to mitigate the risk of being liquidated.
In traditional finance, liquidation refers to when a company or group needs to sell some of its assets at a discount to cover a debt. DeFi liquidations are similar, where users take out debt from a protocol and provide crypto assets as collateral to back the debt.
However, if the debt value starts getting close to eclipsing the collateral's value, the smart contract will automatically allow third parties to bid on the collateral to cover the debt that is outstanding to the DeFi protocol. Thus, DeFi liquidation is the process by which a smart contract sells crypto assets to cover the debt.
Let's say that a user leverage ETH on MakerDAO and the current price of ETH is $1,000. The user locks up 10 ETH into an ETH-A Maker Vault and borrows 5,000 DAI as collateral. Note: the ratio between the outstanding debt and the value of the collateral is known as the collateralization ratio (c-Ratio). So if the user locks up the 10 ETH ($10,000 worth of ETH) and borrows 5,000 DAI they have a c-Ratio of 200% (10,000/5,000 x 100).
The user gains leverage against ETH if they take their borrowed DAI and purchase ETH with it. Now they have more exposure to the ETH price, having bought 5 more ETH.
However, this means they now have more risk if the price of ETH goes down since they have a debt denominated in DAI, while the collateral and the asset they purchased are both ETH.
This particular Maker Vault requires that you maintain a c-Ratio above 150%. If the position drops below 150% then the underlying ETH can be sold in an auction at a discounted price. As a result, liquidation is the process of the MakerDAO smart contracts auctioning off collateral to make sure that the outstanding DAI debt is paid back.
Users that are interacting with lending protocols should always maintain a relatively large buffer between the collateral and the debt that was borrowed, especially if the collateral is a volatile asset.
Additionally, there are powerful tools such as DeFi Saver that will automatically repay your vault to save your c-Ratio from liquidation. DeFi Saver allows some of the collateral in the vault to be automatically sold to repay the debt whenever the vault owner reaches a lower c-Ratio. DeFi Saver effectively acts as an automated stop-loss to prevent your collateral balance from being liquidated.