Decentralized Liquidations: Critical Knowledge for DeFi Borrowers

When a borrower takes out a loan from a DeFi protocol, they are typically required to post collateral valued higher than the loan as insurance for the lender. Platforms need protection in case the assets borrowed lose too much value before being paid back. If collateral value drops below a certain threshold compared to the stablecoins borrowed, the DeFi platform will "liquidate" the position to recoup funds.

This beginner's guide will explain the mechanics of DeFi liquidations, why they occur, how to monitor liquidation risk for positions and share unique examples to solidify understanding of this key concept for decentralized lending.

What Triggers a Liquidation

Most DeFi lending protocols utilize an underlying algorithm to track the collateral value relative to stablecoin loans issued to determine if a position is adequately collateralized. The lending platform must liquidate undercollateralized positions to ensure user funds can be repaid. Two key metrics are used:

1. Collateralization ratio

The percentage value compares collateral deposited vs stablecoins borrowed. For example, 200% would mean $2 worth of crypto assets deposited for every $1 borrowed. This ratio must stay above a minimum threshold like 150%.

2. Oracle price feed

Real-time data provider on current market prices for crypto assets used as collateral. If prices drop, so does the collateralization ratio.

Liquidations are triggered automatically by smart contracts when the oracle price data pushes the collateralization ratio below the platform-defined minimum. By liquidating undercollateralized loans immediately, the protocol ensures it can sell the collateral and get repaid if borrowers default.

A Simple Liquidation Example

Let's walk through a basic liquidation example to better understand the mechanisms:

Mike wants to borrow $1000 USDC using his ETH as collateral on the Aave DeFi lending platform.

1. Aave requires an initial collateral ratio of 200% for loans, so Mike deposits $2000 worth of ETH into an Aave collateralized debt position (CDP).

2. The price feed oracles show ETH trading at $2000 per coin, so Mike's 2 ETH deposit adequately covers the $1000 USDC loan.

3. ETH prices suddenly crash 50% to $1000. Mike's 2 ETH is now only worth $2000 total.

4. The collateralization ratio falls below 150% ($2000 collateral / $1000 debt = 150%).

5. Aave immediately liquidates Mike's 2 ETH at the market rate to repay the outstanding $1000 USDC debt.

In this example, the automatic liquidation protects the lender from Mike defaulting with underwater collateral due to the crash in ETH prices. Mike is left with no ETH and no debt, allowing Aave to recoup capital and minimize risk.

Why Do Liquidations Occur

Now that you know mechanically how liquidations work, you may be asking - why are liquidations and over-collateralization needed in DeFi lending? Can't the platforms just trust users to manage their own risks?

The answer ties back to the permissionless and pseudonymous nature of blockchains. When dealing with unknown users, DeFi protocols create self-enforcing mechanisms like liquidations so loans get repaid regardless of user behavior, even in extreme market crashes. Two key reasons they are necessary:

1. Avoid bad debt and insolvency - In traditional finance, lenders rely heavily on assessing creditworthiness of borrowers to estimate the risk loans won't be repaid. DeFi platforms have no way to reliably vet every anonymous user for creditworthiness. Strict collateral rules and liquidations provide the confidence for protocols to lend without defaults.

2. Incentivize responsible borrowing - Overcollateralization commitments coupled with liquidation penalties incentivize prudent risk management by borrowers. No one wants to get liquidated at the bottom of sudden swings, so these mechanisms encourage users to think carefully about setting collateral ratios prudently for their risk tolerance.

In summary, liquidations are key to DeFi lending by acting akin to margin calls in the traditional financial world. They protect protocols and users alike against excessive default risk due to blockchain anonymity and volatile crypto markets. Liquidations translate that risk into transparent collateral rules for all market participants.

Monitoring Liquidation Risk 

Understanding the risk of liquidations occurring is crucial knowledge for DeFi users looking to borrow funds or provide lending liquidity. Many platforms provide data dashboards to view loan health metrics and monitor how close current positions sit to liquidation thresholds. Let's explore the key data points to watch:

Collateralization Ratio - Current % showing collateral value against loan amount borrowed. Higher is safer with 150-200% being common.

Liquidation Price - A projected price that would trigger liquidation based on the gap between the current collateral ratio and the liquidation threshold (e.g. 150%). This shows the margin of safety before liquidation could occur.

Liquidation Penalty - Percentage fee charged if a position gets liquidated, usually 5-10% of collateral value. This covers transaction costs for the lending platform.

Monitoring these data points provides situational awareness of DeFi lending risks. Some additional tips include:

- Set price alerts on liquidation prices for collateral assets

- Review positions after significant market volatile to ensure adequate buffers

- Maintain collateral ratios well above the minimum required 

Following prudent risk management practices is complementary to the automated liquidation protections in place.

Liquidation Monitoring Examples

To make liquidation monitoring more tangible, let’s walk through a few examples showing how to interpret key risk metrics for positions, and how liquidation prices can be used to manage risks accordingly:

Example 1) Avoiding Liquidation During Volatility

• Alice deposits $10,000 worth of WBTC to borrow $6,000 USDT on Aave
• Her current collateral ratio is 166% ($10k collateral for $6k loan)
• The liquidation ratio for WBTC on Aave is 146%
• This means liquidation would occur if the WBTC collateral value drops to $8,760 (146% of $6,000)
• Alice sees massive volatility strikes WBTC prices due to wider crypto sell-off
• Alice checks Aave and sees the liquidation price for her position is now $8,850 if prices continue falling
• To prevent getting liquidated as WBTC fluctuates, Alice repays $1,000 USDT of her loan, raising her collateral ratio back to safer levels

This example demonstrates how monitoring liquidation prices can inform preventative actions like partial loan repayments to mitigate liquidation risks during periods of peak volatility.

Example 2) Setting Price Alerts to Avoid Liquidation

• Bob takes a $10,000 USDT loan from Compound using $20,000 worth of UNI as collateral
• His position has a healthy collateral ratio of 200%
• However, the liquidation ratio for Compound is 128%
• This means Bob's position would get liquidated if his UNI collateral value drops below $12,800
• UNI prices have seen major declines over the past month
• Bob sets a price alert at $15 per UNI, which would trigger liquidation at current collateral/debt levels
• When the price alert goes off as UNI trades near $16, Bob repays $5,000 USDT of his loan as a precautionary buffer 

By proactively setting price alerts tied to liquidation risks, DeFi users can monitor positions without constantly checking in and manually repay portions of loans if certain threshold breaches occur to avoid getting liquidated.

Liquidation Prediction Dapps

More advanced DeFi users can also leverage liquidation monitoring services like Ape Board which aggregate data across lending protocols to provide liquidation predictions for at-risk collateral positions.

These dapps analyze historical liquidation patterns across platforms like Aave and Compound. The data is then used to predict the chance of liquidation occurring for collateral assets based on criteria like:

- Recent price drawdowns
- Current collateral ratios
- Historical liquidation frequency
- Lending platform liquidation thresholds

By compiling predictive analytics on liquidations probabilities, these tools help risk managers model and avoid excessive exposure to liquidatable positions across volatile DeFi lending markets.

Liquidation Protection Strategies

The above examples demonstrate ways DeFi users can monitor and mitigate liquidation risk through proactive position management. Here are a few additional liquidation protection strategies to consider:

Set Extensive Price Alerts - alerts well above probable liquidation ranges based on volatility

Temporary Risk Buffers - repay a % of loans to periodically raise collateral ratios

Limit Position Sizes - cap maximum capital at risk per position and collateral type 

Balance Platform Exposure - diversify collateral across protocols with varying liquidation behaviors 

While experienced traders may aim to push risk tolerances to maximize yields, it's generally wise for most to maintain reasonable diligence across lending positions and collateral assets. Ultimately liquidations are designed to keep protocols solvent - so the simplest way to avoid them is through prudent position management.

Recovering From Liquidations

Despite best efforts, even seasoned DeFi operators can get caught offsides by unprecedented “black swan” events triggering cascading liquidations with little warning. For anyone finding themselves thrust into this worst case scenario, here are some damage control options:

Seek arbitrage opportunities - liquidated assets may trade below intrinsic value on dex interfaces triggering fire sale arbitrage openings 

Consider collateral shifts - rotate remaining positions into historically resilient assets less tied to high correlation drawdowns

Rebuild positions gradually - moderately re-enter previously liquidated positions at safer collateral ratios as markets stabilize

While emotionally difficult, traders recovering from liquidations should avoid �revenge trading�. Objective risk-assessment, prudent position building, and scaling back overexposed trading habits will provide the best path from heavily liquidated positions.

Conclusion

With great innovation comes great responsibility. DeFi introduces powerful but risky financial tools without the guardrails traders may be accustomed to. Understanding position risks - specifically the implications of liquidations - becomes a prerequisite for engaging prudently while avoiding ruin. Monitor positions diligently, brace for volatility, and know your risk limits.

Liquidations will remain a pivotal mechanic allowing permissionless DeFi lending to scale safely. But by arming yourself with risk management tactics covered here you can help avoid becoming just another liquidation statistic while advancing adoption of these revolutionary protocols. With preparation and responsibility, DeFi touchdowns and strikeouts alike contribute to this grand financial experiment writing the history books before our very eyes.

*Not financial advice. Please do your own research

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