What is DeFi liquidation?
DeFi liquidation is a process that occurs when the value of a borrower's collateral in a DeFi agreement falls below a certain threshold.
This process is a potential risk for both parties involved due to the volatility of cryptocurrency values.
Participants may mitigate the risk of liquidation by maintaining a margin between their collateral and the asset they're borrowing.
Understanding DeFi Liquidation
Decentralized Finance, or DeFi, provides an alternative method to access borrowing agreements outside of traditional finance. Participants put up a crypto asset as collateral for the agreement. However, due to the volatility of cryptocurrency values, participants face an increased chance of their agreement going into liquidation. In this scenario, they lose their collateral. This presents unique risks for the participant and the DeFi space as a whole.
The Risk of Crypto Collateral
In DeFi, initiating a borrowing agreement means providing crypto collateral. The value of cryptocurrency is volatile, meaning the value of the collateral can change significantly over a short period. If the collateral's value falls, it's no longer useful to the DeFi lender as a guarantee. This presents a higher level of risk for the participant, who bears the risk of losing their collateral.
DeFi Liquidation: An Example
Let's say you've initiated a borrowing agreement on a lending protocol, and you gave your valuable cryptocurrency as collateral. If the market value of that cryptocurrency goes below a certain point (the liquidation threshold), the protocol will automatically liquidate your agreement, auctioning off your collateral for less than its value. You lose your collateral, not because you couldn't repay, but because the market decided your collateral was worth less. In DeFi, the participant is at the mercy of the market.
DeFi Risks for Lenders
DeFi also presents potential risks for lenders. The volatility of crypto means a bigger risk for lending protocols. If a participant's collateral is liquidated, there's a potential risk that nobody will want to buy those assets, leaving the protocol unable to recoup their agreement. To mitigate this, protocols will auction off liquidated assets at less than their value, allowing third parties to bid on the assets for a quick sale.
Avoiding Liquidation Risk
If the collateral is volatile, participants may consider maintaining a margin between their collateral and the asset they're borrowing. If the market starts moving, participants may have the option to increase their collateral value by depositing more collateral assets or start repaying the agreement to avoid liquidation. Familiarity with reading smart contracts may be beneficial, as it will allow participants to investigate the protocols they're interacting with and their conditions.
