What are cryptocurrency liquidations and why are they important?

Liquidations have made headlines in the cryptocurrency world news cycle over the past few months. This article will explain liquidation concepts, why liquidations occur, and what people can do to avoid them.

What is cryptocurrency liquidation?

In the field of cryptocurrency, liquidation mainly refers to the forced liquidation of all or part of the initial margin by a trader or asset lender. Liquidations occur when traders cannot meet leveraged position allocations and do not have enough funds to keep their trades running.

Leveraged position refers to mortgage or borrow money with your own existing assets, and then use the mortgaged principal and borrowed money to buy financial products together to gain greater profits.

Most lending protocols, such as AAVE, MakerDAO, Abracadabra and other lending platforms, will set up a liquidation function. According to Footprint Analytics data, on June 18, when the price of ETH fell, there would be a large number of liquidation events in the DeFi market. On the same day, the Lending Agreement liquidated a total of 10,208 ETH, with a liquidation amount of $424 million.

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Footprint Analytics – ETH Liquidation Amount by Protocols

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Footprint Analytics – Number of ETH Liquidation by Protocols

As liquidation progresses, so does the liquidator. They may be large institutions or large households who act as liquidators, buying liquidated assets at a discount and selling them in the market to earn the difference.

Why do cryptocurrency liquidations happen?

In DeFi, pledged loans often occur, and when users do not want to sell their assets, they will mortgage the assets to the loan agreement in exchange for the target assets, and make secondary investments to gain more income. In order to maintain the long-term stable operation of the system, the loan agreement will design a clearing mechanism to reduce the risk of the agreement.

The MakerDAO protocol will be used as an example for analysis:

MakerDAO supports multiple currencies such as ETH, USDC, and TUSD as collateral in order to diversify the risk of protocol assets and adjust the supply and demand of DAI. MakerDAO sets the liquidation line at 150%, which is over-collateralization. This determines the trigger point for liquidation.

When the price of ETH is $1,500, a borrower pledges 100 ETH (worth 150,000) to the MakerDAO protocol, and can lend up to $99,999 in DAI at a 150% pledge rate set by the platform. At this point, the liquidation price is $1,500.

When the price of ETH falls below $1,500, ETH will touch the liquidation line and be easily liquidated by the platform. If liquidated, it would be equivalent to the borrower buying 100 ETH for $99,999.

However, if the borrower does not want to be liquidated quickly, the liquidation risk can be reduced in the following ways:

  • Can Lend Below $99,999 DAI
  • Return loaned DAI and fees before liquidation is triggered
  • Continue to stake more ETH before liquidation is triggered, lowering the liquidation line

In addition to setting a 150% pledge rate, MakerDAO also sets a 13% penalty rule for liquidation. In other words, borrowers who have been liquidated receive only 87% of their top-up assets. 3% of the fine will go to the liquidator and 10% to the platform. The purpose of this mechanism is to encourage borrowers to keep an eye on their collateral assets to avoid liquidations and penalties.

After the liquidation, how will it affect the cryptocurrency market?

During the bull market in the crypto market, some institutions and big players have high-profile and heavy positions, which is the “reassurance” for all currency circles. In today’s falling market, the former bull market promoters have become black swans lining up, each holding encrypted assets that will be liquidated. What’s even scarier is that in a transparent system on-chain, the numbers of these cryptoassets can be seen at a glance.

  • for institutions

Once it encounters a complete liquidation, in addition to bringing greater selling pressure, it may also trigger chain reactions such as related agreements and institutions. Because the loss gap between the borrowing position and the collateralized asset will be forced to cover these protocols and institutions, which will send them into a death spiral.

For example, when stETH was de-anchored, the CeFi institution Celsius was greatly affected, which aggravated liquidity problems and caused a large number of user runs. Institutions were forced to sell stETH in response to users’ demand for asset redemption, and ultimately could not bear the pressure to suspend functions such as account withdrawals and transfers. And Three Arrows Capital holds a large amount of loan positions in Celsius. While Celsius itself cannot be guaranteed, it will certainly affect the pressure of Three Arrows Capital’s assets until it collapses.

  • For DeFi protocols

When the currency price falls, the value of the assets pledged by users on the platform is lower than the liquidation line (the setting of the liquidation mechanism varies from platform to platform), and the pledged assets will be liquidated. Of course, users will quickly sell risky assets when the economy is down to avoid being liquidated. This also directly affects the lock-up volume of DeFi as a whole. TVL is down 57% over the past 90 days.

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Footprint Analytics – DeFi TVL

If the protocol cannot withstand the pressure of a run, it will also face the same risks as institutions.

  • to users

After the user’s assets are liquidated, in addition to losing the assets held, they also need to bear the cost or be deducted by the platform as a penalty. What a painful thing.

summary

Like traditional financial markets, cryptocurrency markets are cyclical. Bull markets don’t last forever, neither do bear markets. At each stage, be cautious and watch your holdings to avoid being liquidated, leading to losses and a death spiral.

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/what-are-cryptocurrency-liquidations-and-why-are-they-important/
Coinyuppie is an open information publishing platform, all information provided is not related to the views and positions of coinyuppie, and does not constitute any investment and financial advice. Users are expected to carefully screen and prevent risks.

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