This is an old article from six months ago, written on January 27, 2022. Now it is being reposted, and the data may differ from the current situation. It is provided for reference reading.
High leverage has been a major characteristic of DeFi since its development. Even though lending platforms require over-collateralization to lend out loans, the borrowed loans can still be used as collateral again, allowing for additional leverage. Some lending platforms even distribute loan certificates, intending to allow other lending platforms to use the collateral assets for further collateralization.
Therefore, with the volatile market, today we will discuss DeFi on-chain liquidation. Before 2020, due to the relatively small amount of funds in DeFi, even if liquidation occurred, it was difficult to significantly impact the market. However, as of today, the total value locked (TVL) in DeFi has reached $92 billion. Once a large-scale liquidation occurs, a situation similar to the stampede event in May 2021 may happen again.
Let's first take a look at the on-chain liquidation levels for BTC and ETH.
In the upper part of the image, there is a distribution chart of liquidation levels for BTC in three major lending markets. The BTC prices are arranged from high to low, right to left. The first major liquidation level is at $25,455, where $360 million worth of BTC will be liquidated at market price. The second major liquidation level is at $20,700, where another $360 million worth of BTC will be liquidated at market price.
In the lower part, the first major liquidation level for ETH is at $1,555, with a liquidation size of approximately $480 million. The largest liquidation level for ETH is at $1,220, with a size of $760 million.
Liquidation itself is not terrifying, but the chain reaction it brings is. Liquidation in DeFi is based on market price. Once the liquidation level is reached, the collateral assets will be sold at market price, causing a significant impact on the market.
Therefore, the cascading liquidation from DeFi lending protocols is one of the most significant systemic risks in the DeFi world. Due to the excessive amount of liquidation and insufficient market liquidity, every time the market experiences drastic changes, it will cause further turmoil, resulting in additional losses for collateral borrowers and exacerbating market volatility.
Now let's briefly explain the logic of DeFi liquidation. However, due to the complexity of the formulas involved, I will mainly provide an abstract explanation here. Specific liquidation methods can be found in the documentation of the corresponding lending platforms.
In DeFi lending platforms, there are generally three roles: lenders, borrowers, and liquidators. Lenders are individuals who lend their idle assets to the lending platforms, depositing funds into the lending pools to earn interest. Borrowers, on the other hand, use over-collateralization to pledge certain assets to the lending platforms in order to obtain loans. Borrowers also need to pay interest to lenders, similar to lenders.
The role that is relatively difficult to understand is the liquidator. In most lending platforms, liquidators appear in the form of robots, but there may also be manual liquidators. Liquidators monitor the blockchain network and the positions in the lending protocols to observe if there are loans with a collateralization ratio below 1. If such loans exist, liquidators intervene to liquidate them and make a profit. In most cases, liquidators are automated tools/scripts that execute block queries, price checks, and attempt liquidation.
In the actual liquidation process, liquidation can be either atomic liquidation with a fixed price difference or non-atomic liquidation in the form of auctions. Atomic liquidation completes the transaction within one block, while non-atomic liquidation involves multiple transactions and interactions with the lending pools through auctions. Non-atomic liquidation often takes 1-2 hours to complete, and in special cases, it may take even longer.
The specific algorithms of liquidation are not described here, but it is important to know that there is competition among liquidators. For example, Aave allows liquidators to purchase collateral assets at a 15% discount from market price. This incentivizes liquidators to increase gas fees in an attempt to quickly acquire liquidated assets and sell them at a significant price difference on other DEX platforms.
Regardless of the method used for liquidation, the ultimate profit for liquidators often comes from quickly selling the acquired discounted collateral assets at market price. This competition for speed can lead to large-scale market sell-offs.
After a wave of DeFi liquidation, the market prices plummet, and due to the leverage in DeFi, a larger area of assets begins to be liquidated. It's like a tsunami, with one wave of liquidation being larger than the previous one. The high leverage in DeFi also makes it more fragile in terms of financial attributes.
Lastly, let's discuss the close relationship between DeFi liquidation and blockchain networks. DeFi liquidation is not just a financial activity. When large-scale liquidation occurs, it can better demonstrate the robustness of a blockchain system. The liquidation contracts of lending platforms, the competition contracts among liquidators, and the interaction between liquidation actions and DEX platforms all occur on a massive scale within a short period of time. This severely tests the robustness of a blockchain system.
A large number of liquidations will trigger more liquidations, just like a domino effect. Low-performance blockchain systems are likely to become paralyzed or experience liquidation delays, resulting in losses for liquidators. Therefore, whether a blockchain network has strong financial attributes depends not only on TPS performance but also on its availability and reliability under high loads. I have to say that the frequent crashes of Solana's mainnet recently have made me lose some faith.
Remember, at no time am I providing investment advice, and I do not even recommend investing in cryptocurrencies. Sometimes, the messages in the background may not be displayed, so you can add me on personal WeChat for communication. But please indicate the purpose.
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Wiseman's Notes - Liu Ye Jing Hong
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