How can DeFi lenders protect against liquidation risk?
Decentralized finance (DeFi) lending offers potentially high rewards of over 20% per year to owners of cryptocurrency who otherwise have a non-yielding asset.
Owners of DeFi assets may take out debt from a protocol and use some of their crypto assets as collateral against that debt. These assets are then used to validate transactions across proof of stake blockchains.
Typically the most active used digital assets at ETH, SOL and Matic, though other coins can also be used.
MATIC to US dollar (MATIC/USD)
The most well known DeFI protocols are Aave, Compound and MakerDAO, though there are numerous others in the sector, with Bloomberg estimating there are around 150 players in the market holding assets worth roughly $100bn at the end of January.
While currently the sector is dominated by retail players the potential returns are attracting institutional investors.
In January, Australian DeFi player Trovio told Capital.com that major investment houses are seriously looking at the sector via its Digital Asset Income Fund which pledges both SOL and ETH.
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Liquidation risk
Outsized returns usually come with similar sized risks and in the lending sector one of the biggest downsides is liquidation risk.
This risk was highlighted in January when nearly $300m assets across 1,000 different positions were liquidated in a matter of days, according to data from sector tracker Dune, quoted by Bloomberg.
The concept of liquidation is well established in the world of conventional finance, where the assets of organizations unable to cover their debts are sold and the money raised from these sales distributed to creditors.
But when the value of that debt reaches an agreed percentage of the value of the assets put up as security for the debt, the insolvency process is not handed over to an authorized practitioner as in the case of a business liquidation.
SOL to US dollar (SOL/USD)
Instead, a smart contact kicks in and automatically alerts third parties of the opportunity to bid on the collateral.
DeFi information service provider Zapper offers the following example:
A user leverages ETH on MakerDAO and the current price of ETH is $1,000. The user locks up 10 ETH into an ETH-A maker vault and borrows 5,000 DAI as collateral. The ratio between the outstanding debt and the value of the collateral is known as the collateralization ratio or c-ratio – so if the user locks up the 10 ETH ($10,000 worth of ETH) and borrows 5,000 DAI they have a c-ratio of 200% (10,000/5,000 x 100).
The user gains leverage against ETH if they take their borrowed DAI and purchase ETH with it. Now they have more exposure to the ETH price, having bought five more ETH.
However, this means they now have more risk if the price of ETH goes down since they have a debt denominated in DAI, while the collateral and the asset they purchased are both ETH.
If the position drops below the minimum c-ratio, the underlying ETH can be sold in an auction at a discounted price.
One of the most contentious aspects of the liquidation process is the incentives (sometimes referred to as liquidation bonuses) lending platforms offer to the buyers of the discounted collateral. Some of these liquidators have automated the liquidation of loans to speed up the process and increase their potential bonus earnings.
Of course, the market value of any asset being sold at a discount will fall, which tends to lead to a sequence of events resulting in further liquidations as panic sets in.
Ethereum to US dollar (ETH/USD)
One of the reasons lenders offer substantial incentives to liquidators is fear of being left holding large amounts of assets whose value has dropped significantly if buyers drop out of the market.
Data from DeFi Explore shows that since the January liquidation peak, relative calm has descended on the market.
From Monday 31 January to Sunday 20 February there were just four liquidations and from Monday 28 February to Sunday 10 April there was an average of just one a week.
According to The Block, Rari Fuse, a DeFi lending protocol which uses assets including USDC, has been the largest source of lending market liquidations since the start of the year, accounting for more than $80m in January and almost all the $23.7m recorded in the first 20 days of April.
Almost a quarter of February’s total came from Aave – whose CEO, Stani Kulechov, told the CryptoCompare Digital Asset Summit in late March that its liquidation mechanism enabled it to survive the crypto price crash of Black Thursday in March 2020.
USDC to US dollar (USDC/USD)
So what can market participants do to minimise their exposure to liquidation? Perhaps the obvious answer is for those who interact with lending protocols to maintain a relatively large buffer between the collateral and the debt that was borrowed, especially if the collateral is a volatile asset.
If this is not possible, apps such as DeFi Saver promise to make collateralized debt positions to borrow funds for use elsewhere, and leveraged positions to long or short supported assets in any of the integrated protocols – both with the option of automated liquidation protection.
The flurry of liquidation activity in January was exacerbated by the number of crypto users attempting to outbid each other to ensure their transactions were processed. The subsequent volume of user traffic would not have made it any easier for traders looking to cut their losses to close their positions.
‘Delta neutral’ DeFi lending
Those looking at alternative protocols might be interested to learn that solana-based (SOL) DeFi protocol Delta One announced earlier this month that it had raised more than $9m to further develop its ‘delta neutral’ trading strategy.
In trading lingo, delta refers to changes in the value of the underlying asset.
Delta neutral is a portfolio strategy that utilises multiple positions with balancing positive and negative deltas so that the overall delta of the assets in question totals zero and the trader ends up with a market neutral exposure.
Co-founder Paul Sengh says the protocol is able to support no liquidations, since it is able to rebalance a yield farmer’s position rather than having to fully close it off.
“It also is feasible to close positions quickly when prices slump because we have a rebalancer bot that runs multiple times an hour,” he says.
Democratizing liquidation systems
Yaron Velner is CEO of B.Protocol, which claims that its backstop liquidity protocol will democratize liquidation systems and shift maximal extractable value (MEV) and bot profits away from liquidators and back to the community.
????B.Protocol developed a Risk Assessment (RA) Framework to analyse DeFi lending platforms.
— B.Protocol (⊟→⊞) (@bprotocoleth) April 14, 2022
????️This was done by our newly launched RA sub-DAO who provides analysis reports upon request.
???? A summary of the 20 page report is available here https://t.co/8xfnv2zbeP ????
He says traders should keep a close eye on their collateral to deposit ratio and agrees with Sengh that it is usually possible to close positions before getting liquidated.
Another route is using options. For example, Hedget promotes itself as an add-on to other DeFi protocols where decentralized lenders – and leveraged traders – pay a premium to protect their position with this fee used to purchase call/put options.
Sengh notes that impermanent loss can be hedged through a basket of options, although Velner is more cautious.
“Options can hedge your portfolio and reduce your loss when the price of the borrowed asset is increasing,” he says. “However, I wouldn't say it is a protection from liquidations.”
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