First, the basics: what exactly is liquidation?
Providing collateral is an age-old norm for borrowers looking to take out a loan. For example, you might use your property as collateral in order to take out a significant loan. Doing so gives the lending institution a sure-fire way of recuperating their money from you, even if you can’t make your repayments. In theory, your house will always be worth at least as much as the loan.
But this guarantee is only effective as long as the collateral itself maintains a steady value – if the price of your house suddenly crashed, for example, the lender wouldn’t have security anymore. Luckily, assets used for collateral normally maintain a steady enough price for this not to be an issue – but in crypto, it’s a different story.
Why Your Crypto Collateral is at Risk
In DeFi, taking out a loan means providing crypto collateral – but the value of cryptocurrency is volatile. The value of the Ethereum or NFTs you used as collateral last week might have completely changed this week and if the collateral itself falls in value, it’s no longer useful to the DeFi lender as a guarantee. To be clear, this problem exists in the traditional finance space aswell – any asset can change in value. But the issue is far more common, and far more pronounced, in DeFi, because the value of crypto is so inconsistent.
So for borrowers, DeFi might represent huge freedom, less red tape and new opportunities for borrowing – but it also presents a higher level of risk when it comes to their crypto collateral. And it’s you, the borrower, who bears that risk.
DeFi Liquidation: An Example
Say you’ve taken out a loan on a lending protocol,and you gave your valuable NFT as collateral – the collection is performing well, and the value of your NFT is fare greater than the amount you’re borrowing. The risks seem low.
But if the market value of that NFT goes below a certain point (something called the liquidation threshold) the protocol will automatically liquidate your loan, auctioning off your NFT for far less than its value.
You just lost your NFT – or whatever collateral you were using – without any opportunity to simply pay back the loan. And it’s not because you couldn’t repay, but because the market decided your collateral was worth less.
In DeFi, you, the lender, are at the mercy of the market.
No matter how much of your loan you’ve paid off, there is always a chance that precious collateral isn’t coming back, and this is all do due to price volatility.
DeFi Risks for Lenders
And what about the lenders?
It might seem like DeFi puts all the risk onto the borrower, but the volatility of crypto means a bigger risk for lending protocols too. It’s not ideal for a lending protocol to be left with collateral assets to sell – there’s always a risk that nobody will want to buy those assets, leaving the protocol unable (still) to recoup their loan.
To get around this, protocols will auction off liquidated assets at less than their value – in DeFi, allowing third parties to “bid” on the assets for a quick sale. This “race to the bottom” negatively impacts the value of the entire currency or collection.
So in short, the way liquidation is managed in DeFi is not only risky for borrowers like you and me, but has an impact across the board, on lenders and currencies generally. This unique marketplace is something that needs to be borne in mind if you’re seeking to borrow yourself.
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