The Sword of Damocles for DeFi Lending Users: The Protocol’s Liquidation Mechanism

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Super high deposit interest in the loan agreement

Is it a bit like the taste of making money by walking and watching videos in the past few years? Yes, how can there be such a good thing.

Apart from the code risk of smart contracts, in most cases, there are not many projects that open single-currency pools for free. Secondly, the so-called coins produced by mining, in the end, you need to sell them to others to realize them and earn money from others, instead of being born out of thin air. This means that if no one buys, the ore you mined is no different from air.

But not all single currency pledges are digging air, because it also has a more practical and stable way of generating income: lending to others for interest. The existence of interest is based on economic principles. The lender not only takes the risk of not getting it back when he borrows the money, but also gives up the opportunity to use the money to make more money or enjoy life during the loan period, so the interest is reasonable and has always existed.

In the DeFi world, what can bring us interest income is the lending agreement, which is similar to banks in the real world, which absorb deposits and issue loans. Depositors get interest and lenders pay interest.

The risk of the loan agreement eating interest

Due to the different calculation methods of interest and the current hot trend of DeFi, the interest in the lending agreement is much higher than that of traditional banks: stablecoin loans with more demand can reach 80% of the annual interest when it is high, and the normal state can also be maintained at 20% %about. The almost risk-free ultra-high interest rate has caused investors outside the circle to buy a large number of stablecoins such as USDT to manage money. It is so delicious that there is also a saying that "this is the meaning of DeFi to ordinary people".

There is no risk. The risk of smart contracts is one aspect, and the risk that is more difficult to grasp lies in "liquidation".

The encryption market suffered a big dive last Sunday, almost across the board fell by nearly 20%. According to DeBank data, on this day, the liquidation volume of the entire network lending agreement in the past 24 hours reached 45 million US dollars, of which AAVE, Venus, and Compound ranked the top three. It is worth mentioning that the Flux lending agreement was liquidated at 0 under the catastrophe of this day.

What is liquidation?

The current mainstream DeFi protocols are mortgage lending. Users can deposit certain assets as collateral before they can make loans. This is the same as people mortgage cars, houses, etc. to obtain funds in reality. Through such an operation, users can obtain more funds to invest without selling the currency they hold, at the cost of corresponding loan interest. Applied properly, it will be a very powerful auxiliary tool for investors in the bull market.

In the DeFi mortgage lending agreement, when the mortgage deposit value exceeds the loan value, the lending agreement works well, allowing borrowers to obtain liquidity without having to sell their assets deposited into the agreement. However, when the value of mortgage deposits falls, or the value of loans rises, borrowers have an incentive to avoid repayments, potentially leaving both depositors and borrowers in trouble.

So there is liquidation, which is an operation triggered when your mortgage assets are not enough to cover your loan. Liquidation will cause the mortgage assets of the deposit to be bought by others, and you may need to pay a certain penalty. Traditional finance is tested and executed by banks or professional clearing institutions, while DeFi is executed by smart contracts and liquidators.

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The main indicator that triggers DeFi liquidation is the ratio of total deposits to outstanding loans. When the total outstanding debt reaches a certain level, liquidation will be triggered.

The proportion of liquidation triggers will vary according to the settings of each product team. Specifically, it will be affected by the market recognition, volatility, liquidity and performance of the blockchain network where the mortgage assets are located.

The liquidation trigger lines of Maker DAO, AAVE, COMPOUND, VENUS and Flux are shown in the figure.

MakerDAO adopts a method that allows users to choose the combination of pledge rate and stable rate, but generally speaking, its liquidation trigger line is at a relatively high position. Venus also uses a very high liquidation trigger.

Flux’s liquidation trigger line is the lowest, and liquidation will only be triggered if the mortgage rate is lower than 110%, which is more friendly to lending users and stronger against extreme market conditions. Flux's relatively uniform liquidation trigger mortgage rate is also more conducive to users understanding their own risks.

The difference in the mortgage rate triggered by liquidation will be reflected in extreme market conditions. Assume that Bob has deposited 100 USD in ETH in each of the above projects and lent 50 USDT. If ETH falls by 20%, Bob’s deposits in Maker DAO and Venus will be liquidated, and the deposits in Compound will also be close to Liquidations, deposits in Flux and AAVE are relatively safe.

Liquidation Execution Efficiency

The level of transaction fees on the chain and the transaction confirmation time will affect the liquidation process. Because the liquidation requires the liquidator to initiate the transaction, the liquidator needs to pay the transaction fee on the chain. When the liquidation income obtained is lower than the transaction fee, no one will carry out the liquidation. This is not good for the whole platform. The handling fee of Ethereum has long been unbearable for ordinary users, and the Gas on the BSC chain is also increasing.

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On the left is the deposit transaction on Flux, the handling fee is 0, and on the right is the handling fee for an Ethereum transaction when the Gas is at a low level of 47, reaching 12 US dollars (calculated based on the ETH price in January this year)

Borrowers of Flux can also take advantage of this advantage. The fast transaction confirmation and zero handling fee on the chain give users more opportunities to complete the repayment or increase the collateral operation before the market changes further, so as to avoid losses caused by liquidation .

Liquidator Proceeds

There are also differences in liquidation logic. Before Flux liquidates, the smart contract will first transfer the liquidator's repayment funds to the loan pool to ensure sufficient funds in the loan pool. And the liquidator can obtain a variety of assets that are liquidated, which is different from AAVE, Venus, and Compound, which can only obtain one of the assets.

The liquidator of AAVE can liquidate up to 50% of the collateral, and must use the loaned assets to repay the liquidation. The reward can only be a certain asset in the deposit. The Compound liquidator can repay all the arrears, but can only choose an asset in the arrears as a reward.

Borrowing is a kind of leverage behavior, and excessive leverage will lead to increased risks. Liquidation is the sword of Damocles hanging over the heads of these overleveraged users. It is a punitive measure, and the existence of liquidation is to protect the interests of lenders and the stable operation of the entire project, and it is also a reminder for investors to grasp investment risks. Clearing requires an efficient mechanism to encourage investors to make prudent investments while balancing the risks of multiple parties, which requires more exploration.