Over the past few months, liquidation has been the most frequently mentioned topic in newspapers across the space cryptocurrency. This article will explain what liquidation is in context crypto, including how it happens and how to avoid it.
What is Cryptocurrency Liquidation?
Liquidation is when a trader or asset lender is forced to close all or part of an initial margin position. Liquidation occurs when a trader is unable to meet the allocation for a leveraged position and does not have enough funds to keep the trade running.
A leveraged position refers to using existing assets as collateral for a loan, and then using the pledged principal and borrowed amount to purchase financial products to generate greater returns.
Most lending protocols, such as Aave, MakerDAO and Abracadabra, all have liquidation functions. On June 18, when the price ETH down, there were 13 events liquidation on the market DeFi. On the same day, loan protocols liquidated 10,208 ETH, with a liquidation amount of $424 million.
Value ETH liquidation by protocol | Source: Footprint Analytics
Accordingly, large institutions or investors can buy liquidated assets at a discount and sell them on the market for the difference.
Why do crypto liquidations happen?
In DeFi, stake lending (staking lending) is when a user pledges assets to the lending protocol in exchange for the target asset and then reinvests it a second time to earn additional income. In essence, it's a form of derivative. To maintain the long-term stability of the system, the lending protocol will design a liquidation mechanism to reduce the risk to the protocol.
For example, MakerDAO supports many different currencies like ETH, USDC and TUSD as collateral to diversify the risk of assets in the protocol and adjust the supply and demand of DAI. MakerDAO has set the stake rate to 150%. This ratio determines the factor that triggered the liquidation.
Specifically, when the ETH price is $1,500, the borrower stakes 100 ETH into the MakerDAO Protocol (worth 150,000) and can borrow up to $99,999 DAI at a 150% stake rate set by the platform. At this point, the liquidation price is $1,500.
If the ETH price falls below $1,500, the ETH will reach the stake rate and be vulnerable to liquidation by the platform. If the position is liquidated, it is equivalent to a borrower buying 100 ETH for $99,999.
However, if the borrower does not want to be liquidated quickly, there are several ways to reduce the risk.
Borrow less than $99,999 DAI.
– Return borrowed DAI and fees before triggering liquidation.
– Continue to stake more ETH before activating the liquidation, reducing the stake rate.
In addition to setting a mortgage rate of 150%, MakerDAO also sets a penalty rule of 13% on liquidation. In other words, liquidated borrowers will only receive 87% of deposited assets. 3% fines will be transferred to the liquidator and 10% to the platform. The purpose of this mechanism is to encourage borrowers to monitor their collateral to avoid liquidation and penalties.
How does liquidation affect the market?
When the market cryptocurrency Prosperity, institutional heavyweight and senior positions, and large-scale users are a “reassurance” for all investors. In the current downtrend, former bull market drivers have become black swans, holding derivatives that could be liquidated at any time. What's even scarier is that in a transparent on-chain system, it is possible to see the number of cryptocurrency liquidated in an instant.
Once fully liquidated, it could trigger a chain reaction across protocols, stakeholders, and others, in addition to bringing in more selling pressure. Because of the protocols, the institution is forced to incur the loss difference between the lending position and the collateral, pushing them into a death spiral.
For example, when stETH loses its peg, the CeFi . organization Celsius was greatly affected, exacerbating liquidity problems and prompting massive user withdrawals. The institution was forced to sell stETH to meet user demand and acquire assets. In the end, they couldn't stand the pressure, which led to the suspension of withdrawal and remittance services. In return, Three Arrows Capital borrowed a large amount from Celsius and Celsius' difficulty in fending for himself is sure to strain assets at Three Arrows Capital until its collapse.
For DeFi . protocols
When the price of the currency falls and the value of the assets staked by users in the platform falls below the liquidation line (the mechanism for setting up the liquidation will vary between platforms), the staked assets will be liquidated. Of course, users will quickly sell risky assets to avoid liquidation during downturns. This also affects TVL (total value locked) in DeFi, down 57% in the past 90 days.
If the protocol cannot withstand the pressure of a bank run, it will also face the same risks as the institution.
When a user's assets are liquidated, in addition to losing their holdings, they are also subject to fees or penalties set by the platform.
As with traditional financial markets, cryptocurrencies are equally cyclical. Bull markets don't last forever, and neither do bear markets. At each stage, it is important to exercise caution and monitor assets to avoid liquidation, which can lead to losses and a death spiral.