The news cycle has been dominated by liquidations in crypto over the past few months. This article will discuss liquidations in crypto. It will also explain how and what you can avoid them.
What is a Crypto Liquidation and how can it help you?
A liquidation refers to the forced closure of all or part a trader’s initial margin position by an asset lender or trader. Liquidation is when a trader cannot meet the allocated leveraged position or does not have sufficient funds to continue trading.
Leveraged positions are when you use your assets to secure a loan or borrow money. The principal will be pledged, and then the borrowed money is used to purchase financial products to increase the profit.
A majority of lending protocols such as Aave and MakerDAO have a liquidation function. Footprint Analytics data shows that 13 liquidation events occurred in the DeFi market on June 18, as ETH prices fell. Lending protocols also liquidated 10,208 Ethereum on the same day with a total liquidation value of $424 million.
Footprint Analytics – ETH liquidation amount by protocols
Footprint Analytics – Numbers of ETH Liquidation By Protocols
With liquidations come liquidators. Investors and large institutions may purchase liquidated assets at a discount price and then sell them on the market to make a profit.
What is the purpose of Crypto Liquidations?
Stake lending in DeFi is where users pledge their assets to the lending protocol to receive the target asset. Then they invest again to make more income. It is basically a derivative. To ensure the stability of the system over the long-term, the lending protocol will create a liquidation mechanism that reduces the risk.
Let’s have a look at MakerDAO.
MakerDAO supports a range of currencies, such as USDC, ETH and TUSD, as collateral to diversify risk and adjust supply and demand for DAI. MakerDAO has established a stake rate, which is over-collateralization, of 150%. This is the trigger for liquidation.
Here’s an example.
A borrower can stake 100 ETH to MakerDAO protocol, which is valued at 150,000, and can loan up to $99999 DAI at the 150% stake rates set by the platform. The liquidation price at this point is $1,500.
If ETH’s price falls below $1500, ETH will reach the stake rate and be subject to liquidation by the platform. It is equivalent to a borrower purchasing 100 Ethereum for $99,999.
There are many ways to minimize the likelihood of liquidation if the borrower doesn’t want to liquidate quickly.
Do not lend more than $99,999 DAIReturn DAI and fees prior to the liquidation trigger. Continue to stake more Ethereum before liquidation triggers, decreasing the stake rate
MakerDAO has also set a 15% pledge rate and a 13% penalty rule in case of liquidation. In other words, liquidated borrowers will receive only 87% of the assets they have. The platform will receive 10% and the liquidator 3%. This mechanism encourages borrowers to monitor their collateral assets in order to avoid penalties and liquidation.
What are the effects of liquidations on the market?
High-profile, large-scale institutional positions and large-scale users can be “reassuring tablets” for investors when the crypto market is healthy. The current downtrend has seen former bull market proponents become black swans, each with derivative assets that can easily be liquidated. Even more frightening is the fact that these crypto assets are visible in transparent systems on-chain.
It could also trigger a chain reaction among related institutions, protocols and other entities, which may increase selling pressure. These institutions and protocols will have to bear the loss gap between the loan position and collateralized assets, which will lead to a death spiral.
CeFi institution Celsius was severely affected by stETH’s off-anchor. This led to liquidity problems and a huge run on users. In response to users’ demands to redeem their assets, the institution had to sell stETH and was ultimately unable to withstand the pressures to suspend withdrawals and transfer accounts. Three Arrows Capital has a large loan position in Celsius. This will affect Three Arrows Capital’s ability to protect itself and their asset stress problem.
The staked assets will be liquidated if the currency’s price falls or the value of assets staked by platform users falls below the liquidation limit (the mechanism to set up liquidation will differ from platform-to-platform). Users will quickly sell their risky assets to avoid liquidation during a downturn. DeFi’s TVL has also been affected by this, with TVL falling 57% in the last 90 days.
Footprint Analytics – DeFi TVL
If the protocol is unable to withstand the pressure of a run it will face the same risks that the institution.
Users who liquidate their assets will lose all of their holdings and may also be subject to penalties or fees from the platform.
Like traditional financial markets, cryptocurrency markets can also be cyclical. Bull markets and bear markets are not sustainable. It is crucial to remain vigilant at each stage to avoid losses or a death spiral.
Shouldn’t the resilient economy of the crypto world be governed by smart contracts?
Footprint Analytics community contributed this piece in July. Vincy 2022
Data Source: Footprint Analytics – ETH Liquidation Dashboard
The Footprint Community is where crypto and data enthusiasts from all over the world can come together to share their knowledge and insights on Web3, DeFi, GameFi and other areas of the emerging blockchain technology. You’ll find diverse voices that support each other and drive the community forward.
What is crypto liquidation and why are they important? CryptoSlate.
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