Making sense of Defi concepts - Liquidation

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In one of my previous posts, I have talked about AMM and risk of impermanent loss and MakerDao.

In this post, I will talk briefly about the main risk of participating in lending and borrowing Defi protocols eg. Makerdao, Aave - which is liquidation and what can lead to it.



Source: Reddit, 13 May 2021


It seems like the current trend is gaming or milking protocols that offer reward for depositing / lending as well as borrowing. Yes, you hear it right - you get rewarded for borrowing too. Since it's on Reddit, I guess it's no big secret...


Shiok ar!


A reason I could think of for giving out the reward is to get more people to use the new tokens in the new (L2) network. Create hype!


A safeguard to the protocol for such borrowing activities would be to ensure that all loans taken are over-collateralized. Means as a borrower, you can only borrow a certain percentage of the collateralized crypto asset in the form of another crypto asset. When this threshold is breached, you would run into the risk of liquidation of your collateral and suffer a liquidation penalty.


"A liquidation is a process that occurs when a borrower's health factor goes below 1 due to their collateral value not properly covering their loan/debt value. This might happen when the collateral decreases in value or the borrowed debt increases in value against each other."
[Source: Aave faq doc]


In Aave, the collateralization amount typically ranges from 50 to 75% of the loan amount. Borrowers must maintain the collateralization ratio. If they don’t, other users can liquidate them. And they will be incentivized to do so by buying out their undercollateralized position for a discount." (This discount may also be called liquidation bonus in another form.)
[Source: https://academy.ivanontech.com/blog/defi-deep-dive-what-is-aave]


To game or be gamed?


To avoid getting roasted by liquidation, key things to watch out for would be the Loan-to-Value rate and Variable APY.


Loan-to-value (LTV) rate


If what you collateralized asset falls in value or what you borrowed rises in value, then your LTV will increase. (In another words, your health factor will drop.) 

To prevent liquidation from happening, you have to repay back a part of your borrowed asset + interest, or increase your collateral amount.


Bear in mind that this requires gas fee. If you are on L1 (mainnet) and the market crashes like what happened recently, the gas fee would sky-rocket and you might have no chance of doing repayment or topping up of collateral to bring down your LTV without paying exorbitant fees to get your transactions settled i before liquidation kicks in.


Variable APY


The protocols have 2 types of lending APY, namely variable and stable. However, some assets only allow for 1 type of APY which, most of the time, is Variable APY. This means that it can be adjusted anytime depending on the supply / demand and whatever else that the smart contract specifies.


If the borrow APY increased dramatically and beyond what can be compensated by the reward, then you might have to repay back a lot more than what you have initially borrowed.


"...during the last yield farming craze, the borrow APY on the BAT token went up to over 40%. This could cause unaware users who were not tracking Compound interest rates daily to get liquidated by having to repay more than expected in the same period of time."



Thus, prospecting the asset type that you deposit and borrow is important. Collateralize what you think will go up in value so that you won't be caught with your pants down.


Do note that usually assets of higher volatility are compensated with higher yields when participating in such protocols.


DYODD and stay vigilant.

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Disclaimer: Contents of this blog are personal opinions and NOT financial advice to buy or sell any mentioned securities, commodities or assets.

Comments

  1. Daniel Anthony07/08/2021, 20:50

    Wow what a Great Information about World Day its very nice informative post.
    thanks for the post.polygon

    ReplyDelete

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