Surviving the DeFi Jungle: Essential Truths and Tips to avoid Liquidations

Introduction

DeFi liquidations are a lurking threat that every crypto investor must face. Discover the truths about liquidation mechanisms, the unexpected causes, and the jaw-dropping incidents that have rocked the crypto world. Generating yield and unlocking the liquidity for additional profits comes at risk which can be carefully managed. Learn how to protect yourself from losses with cutting-edge solutions that Joule Finance is pioneering.

DeFi has introduced financial protocols for direct lending and borrowing on platforms, eliminating intermediaries. Lenders provide assets to a liquidity pool, receiving interest, while borrowers provide collateral. This blog explores liquidation, an economic risk associated with DeFi lending protocols, the intricacies of liquidation mechanisms, common causes, notable incidents, and innovative solutions to provide readers with a comprehensive understanding.

Liquidation in DeFi serves as a safeguard mechanism to maintain the integrity of lending protocols. It occurs when a borrower’s collateral value falls below a specified threshold, prompting the protocol to sell off the collateral to cover the outstanding debt. This process ensures that lenders are protected from potential losses and contributes to the overall stability of the DeFi ecosystem.

Types of Liquidations

Full Liquidations

In a full liquidation, the entire collateral is sold off to cover the outstanding debt. This ensures that the lender’s funds are fully recovered but can be harsh for the borrower, resulting in the total loss of their collateral. Full liquidations are common on platforms that do not support partial liquidations or in cases where the collateral value drops significantly.

Partial Liquidations

Partial liquidations involve selling only a portion of the collateral to bring the collateralization ratio back to a safe level. This approach mitigates the impact on borrowers by preserving some of their collateral while still securing the lender’s position. Partial liquidations help avoid the total loss of collateral for borrowers and can be seen as a more borrower-friendly approach. Some platforms experimenting with partial liquidations include Nolus and Fringe Finance.

Causes of Liquidations & Major Historic Events

1. Market Volatility
   Cryptocurrency markets are highly volatile, and sudden price fluctuations can trigger liquidations if collateral values drop below the required threshold. During the March 2020 market crash, known as “Black Thursday,” the value of many cryptocurrencies, including Ethereum, plummeted. This caused widespread liquidations across various DeFi platforms, notably MakerDAO, which faced a liquidity crisis. Borrowers’ collateral values fell below the required thresholds, triggering liquidations to maintain protocol solvency.
2. Oracle Issues
   Oracles provide critical price feeds to DeFi protocols. Incorrect or delayed data from oracles can lead to improper liquidations. In November 2020, the Compound protocol experienced an oracle feed error that led to the liquidation of $89 million worth of collateral. This incident underscored the importance of reliable and accurate oracle systems in DeFi.
3. Borrower’s Ignorance

• High Leverage: Borrowers sometimes take on more debt than they can handle, using high leverage. This increases the risk of liquidation as even small market movements can significantly impact their positions. In 2022, the main cause of collapse of the famous Three Arrows Capital was excessive leverage on long positions across various cryptocurrencies and their derivatives in addition to the collateralization risk involved with lending markets.
• Lack of Monitoring: Some borrowers do not actively monitor their positions and the market conditions, leading to unawareness of critical situations that require immediate action to avoid liquidation.
• Complex Protocol Rules: DeFi protocols can have complex rules and mechanisms for liquidation that borrowers may not fully understand. Misunderstanding the terms and conditions of their loans can lead to unexpected liquidations.
• Insufficient Collateralization: Borrowers might not provide enough collateral to safeguard against market swings, assuming that the prices will remain stable or move in their favor.
• Ignoring Liquidation Fees: Liquidation processes often come with fees that can further reduce the borrower’s remaining collateral. Ignorance of these fees can lead to greater financial losses than anticipated.

4. Price Manipulations
Malicious actors can manipulate asset prices to exploit vulnerabilities in DeFi protocols, triggering liquidations. In October 2022, Avi Eisenberg manipulated the price of Mango’s native token to artificially inflate its value, causing improper liquidations and resulting in a $110 million exploit. This incident demonstrated the risks of price manipulation in DeFi.

5. Smart Contract Bugs and Vulnerabilities
Bugs or vulnerabilities in smart contracts can lead to unintended liquidations. The bZx protocol suffered from multiple exploits due to smart contract vulnerabilities, leading to significant losses and liquidations. These incidents highlighted the critical need for robust smart contract security.

Innovations to Mitigate Liquidation Risks

Several innovative approaches are being developed to mitigate the risks associated with liquidations in DeFi.

• Isolated Lending

Isolated lending involves isolating each loan position to limit the risk exposure. This approach prevents a cascading effect of liquidations across the platform. In isolated lending, each borrowing position is treated separately, which helps contain risks and prevent systemic failures. Joule Finance is pioneering this approach in the Aptos and overall Move-based ecosystem for a safer customer experience.

• Reversible Calls

Reversible calls are being explored as a potential solution to reduce the risk of premature or erroneous liquidations. This method allows a temporary reversal of a transaction to mitigate the impact of incorrect liquidations. Though still in the early stages, reversible calls could provide a way to address liquidation events triggered by erroneous data or manipulations.

How Liquidations are Handled?

Below, we delve into the detailed mechanics of liquidations, the factors considered, the parties involved, and how various renowned DeFi lending protocols handle liquidations.

Parties involved in the Liquidation Process

• Borrowers — Take out loans by providing collateral. They risk losing their collateral if their loan’s health factor falls below the required threshold.
• Lenders — Deposit assets into the protocol to earn interest. The liquidation process ensures their funds are protected from default risks.
• Liquidators — Participants who actively monitor for under-collateralized positions. They trigger the liquidation process and receive a portion of the collateral as a reward.
• Smart Contracts — Automate and enforce the liquidation process, ensuring that it is carried out fairly and efficiently.

Factors Considered in the Liquidation Process

1. Collateral Value and Borrowed Amount

• Dynamic Market Evaluation: Real-time assessment of collateral value is crucial, as crypto markets are highly volatile. Oracle feeds provide accurate market prices, ensuring fair liquidations.
• Loan-to-Value Ratio (LTV): Higher loan amounts relative to collateral increase liquidation risk. LTV ratios vary across assets, with more volatile tokens requiring lower LTVs to mitigate risk.

2. Health Factor and Liquidation Threshold

• Borrower’s Position Health: The Health Factor Distribution indicator tracks how close a position is to liquidation. If the health factor is below 1, it can be liquidated, resulting in a loss to the borrower. The Health Factor Distribution indicator shows the share of borrowers within a particular range of health factors, excluding recursive loans.

This indicator is useful for analyzing the different ranges of the protocol’s borrowers. If most of the supply has a low health factor, the solvency of the pool/protocol is at risk due to big liquidations.

• Protocol-Defined Thresholds: Liquidation thresholds, slightly higher than LTV ratios, trigger liquidation when breached. This ensures borrowers maintain adequate collateralization to protect lenders’ funds.

3. Liquidation Penalty and Incentives

• Risk Mitigation Mechanism: Liquidation penalties deter borrowers from allowing their positions to become undercollateralized. The penalty compensates liquidators for their efforts and covers potential losses due to market volatility.
• Liquidator Rewards: Incentivizing liquidators with bonuses encourages active participation in the liquidation process, ensuring timely and efficient risk management within the protocol.

4. Monitoring Tools and Whale Activity

• Risk Assessment Tools: Advanced monitoring tools, such as IntoTheBlock’s Risk Radar, provide insights into the protocol’s risk level. Monitoring health factor distributions and volatile asset loans helps identify and mitigate potential risks.
• Whale Influence: Large holders’ actions can significantly impact market dynamics and protocol stability. Continuous monitoring of whale activities allows for proactive risk management and mitigation strategies. These metrics offer insights into whale behavior within the protocol.

By analyzing liquidation history, borrowers can evaluate lending risks. Examining repays and total debt helps forecast whale behavior. The current borrow share allows liquidators and lenders to anticipate potential whale liquidations.

The Liquidation Handling Process

1. Identification of Under-Collateralized Positions

• Health Factor Monitoring: Smart contracts continuously monitor borrowers’ positions, flagging those below a safe threshold.
• Smart Contract Automation: Ensures rapid response to market changes, maintaining protocol security.

2. Triggering Liquidation

• Role of Liquidators: Liquidators initiate the process upon identifying risky positions, securing a reward for their service.
• Execution by Smart Contracts: Protocol’s smart contracts seize the required collateral amount, covering the loan and any penalties.

3. Selling Collateral

• Repayment of the Loan: Seized collateral is sold, repaying the outstanding loan.
• Distribution of Liquidation Bonus: Liquidators receive a portion of the collateral as a reward, varying by protocol.

How Renowned DeFi Lending Protocols handle Liquidations

One important fact about large protocols like Aave and compound is that they monitor hundreds of risk parameters simultaneously with live simulations of the market conditions to remain at the forefront to fight liquidations. Liquidators receive a portion of the collateral as a reward, varying by protocol.

1. Aave

• Health Factor Calculation: Aave uses a health factor to gauge loan risk. If it falls below 1, liquidation is triggered.
• Liquidator Incentives: Liquidators receive a liquidation bonus, which varies by asset. For example, liquidating ETH might carry a 5% bonus.
• Partial Liquidations: Aave allows for partial liquidations, reducing the burden on borrowers by only liquidating a portion of the collateral needed to restore the health factor.

2. Compound

• Collateral Factor: Compound’s collateral factor determines borrowing capacity. Falling below this factor triggers liquidation.
• Discount Incentives: Liquidators get a discount on collateral during liquidation, incentivizing their participation.
• Automated Smart Contracts: Compound’s smart contracts handle the entire liquidation process, from identifying risk to selling collateral.

3. MakerDAO

• Collateralization Ratio: Loans must maintain a certain collateralization ratio. Falling below this ratio triggers liquidation.
• Auction Mechanism: MakerDAO uses auctions to liquidate collateral, ensuring maximum recovery value.
• Stability Fees: Borrowers pay stability fees, impacting the overall cost and timing of liquidations.

Joule’s Pioneering Approach on Aptos — Liquidation Handling in Isolated Lending Positions

Isolated lending, is a specialized form of lending DeFi protocols. Unlike traditional lending, where collateral is pooled together, isolated lending allows borrowers to designate specific collateral for each loan, creating isolated positions. Liquidation handling in isolated lending positions involves unique considerations and mechanisms tailored to individual positions.

1. Isolated Position Management

• Individual Collateralization: In isolated lending, borrowers can allocate specific collateral assets to each loan, ensuring that each position is independently collateralized. This allows for granular risk management and mitigates the impact of liquidations on other positions.
• Customized Liquidation Parameters: Isolated lending protocols typically allow borrowers to set custom liquidation thresholds and health factors for each isolated position. This flexibility enables borrowers to tailor risk management strategies to individual positions based on asset volatility and market conditions. Joule is committed to focus on the risk customization catering to different risk appetites of the borrowers in the near future.

2. Liquidation Triggers and Execution

• Position-Specific Liquidation Thresholds: Each isolated position has its own liquidation threshold, determined by the borrower. When the value of the collateral in a position falls below its liquidation threshold, the position becomes eligible for liquidation.
• Automated Liquidation Execution: Similar to traditional lending protocols, isolated lending platforms utilize automated liquidation mechanisms triggered by smart contracts. When a position meets the liquidation criteria, the smart contract initiates the liquidation process, selling the collateral to repay the loan.

Conclusion

Surviving the DeFi battlefield requires more than just knowledge — it’s about being proactive and taking suitable steps. While the risks are real, innovative solutions like Joule Finance is offering on Aptos and the overall Move ecosystem are paving the way for a safer future. Equip yourself with these insights to stay one step ahead and hone abilities to multiply the profits.

Effective liquidation management is essential for DeFi stability and security. By understanding the risks and implementing strategies to mitigate them, you can protect your investments and thrive in the DeFi jungle. Stay informed, stay vigilant!