Recently, purges have been at the top of cryptocurrency news, as we reported on Cryptokoin.com. In this article, we’ll look at how liquidations happen and what can be done to avoid them.
What is cryptocurrency liquidation?
Liquidation is the forced closing of an initial margin position by an investor or asset lender. It also occurs when an investor cannot afford the allocation of a leveraged position and does not have sufficient funds. A leveraged position means using your current assets as collateral for a loan or loan and then using the previously pledged principal and borrowed money to buy financial products together to make a bigger profit.
Most lending protocols such as Aave, MakerDAO, and Abracadabra have a liquidation function. According to Footprint Analytics data, there were 13 liquidations in the DeFi market on June 18, when the price of ETH fell. On the same day, lending protocols liquidated 10,208 ETH with a liquidation amount of $424 million. Besides, with the purges come the liquidators. Large institutions or investors can purchase liquidated assets at a discounted price. Likewise, they can sell in the market to earn the difference.
Why are cryptocurrency liquidations happening?
In DeFi, betting credit is where users pledge their assets to the lending protocol in exchange for the target asset and then re-invest it a second time to earn more income. It is essentially a derivative. To maintain the long-term stability of the system, the lending protocol will design a liquidation mechanism.
MakerDAO supports various currencies such as ETH, USDC and TUSD as collateral to diversify the risk of protocol assets and adjust the supply and demand of DAI. MakerDAO has set an odds ratio of 150 percent, which is over-collateralized. This sets the trigger for the purge. For example:
MakerDAO supports various currencies such as ETH, USDC and TUSD as collateral to diversify the risk of protocol assets and adjust the supply and demand of DAI. MakerDAO has set an odds ratio of 150%, which is over-collateralised. This sets the trigger for the purge. Here is an example:
- When the price of ETH was $1,500, a borrower deposited 100 ETH (worth 150,000) in the MakerDAO protocol. It also lent up to $99,999 DAI at a 150 percent stake set by the platform. At this point, the liquidation price is $1,500.
- If the price of ETH drops below $1,500, ETH will hit the odds. However, it will remain vulnerable to liquidation by the platform. If liquidated, the equivalent of a borrower buying 100 ETH for $99,999.
Ways to reduce the risk of liquidation
If the debtor does not want to be liquidated quickly, there are several ways to reduce the risk of liquidation.
- Lend less than $99,999 DAI
- Refund of DAI and fees loaned before the liquidation trigger
- Reduce the odds by continuing to deposit more ETH before the liquidation is triggered
- MakerDAO sets a 150 percent pledge rate. It also sets a 13 percent penalty rule for liquidation. In other words, liquidated debtors will only receive 87 percent of their upload assets. 3 percent of the fine will go to the liquidator and 10 percent to the platform. The purpose of this mechanism is to encourage borrowers to keep an eye on their collateral assets to avoid liquidation and penalties.
How do liquidations affect the market?
In the current downtrend, former bull market backers have become derivatives assets, each of which can be liquidated. Even more frightening is that in the transparent on-chain system, the numbers of these crypto-assets can be seen. When institutions are subject to liquidation, they get more selling pressure. Besides, it triggers a chain reaction of related protocols, institutions and others.
Celsius, for example, was heavily affected by the purges. It also exacerbated the liquidity problems and caused a huge problem on users. The institution was forced to sell stETH in response to users’ demand to buy back their assets. In the end, the account could not withstand the pressure to suspend withdrawals and transfers. In contrast, Three Arrows Capital has a large lending position in Celsius. Celsius’s difficulty in protecting itself will affect Three Arrows Capital’s asset stress problem until it collapses.
DeFi protocols and users are also affected by the purges
When the price of the currency drops and the value of the assets deposited by users on the platform falls below the liquidation line (the mechanism for setting up liquidation will vary from platform to platform), the deposited assets will be liquidated. Of course, users will quickly sell risky assets to avoid liquidation in a downturn. This also affects DeFi’s TVL, which has seen TVL drop by 57 percent over the past 90 days. If the protocol fails to withstand the pressure of a run, it will face the same risks as the institution.
When a user’s assets are liquidated, in addition to losing their assets, they are also subject to fees or penalties charged by the platform. Like traditional financial markets, cryptocurrency markets are equally cyclical. Also, bull markets don’t last forever, and bear markets don’t either. That’s why, at every stage, it’s important to watch your assets closely to be careful and avoid liquidation.
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