DeFi Liquidation: What it is, and How to Avoid it

In the context of decentralized finance (DeFi), liquidation occurs when the value of a borrower’s collateral falls below the agreed threshold. DeFi borrowing typically sees borrowers put up collateral of between 1.5 to 3 times more than the borrowed amount, with the loan typically delivered to the borrower in the form of stablecoins such as USDC, Dai, USDT, or others.

However, the collateral put up by borrowers is usually in the form of crypto tokens like Bitcoin, Ethereum, Polygon, and others. Because these assets tend to be highly volatile, there’s always a risk that their value could fall below the sum required as collateral – even if they matched it when the loan was first taken.

Major DeFi lending platforms like MakerDAO, Compound and Aave differ in how they approach liquidation, with some liquidating all of a user’s collateral, and others only liquidating part of it.

Let’s take a look at some of the steps DeFi users can take to avoid the threat of having their collateral liquidated and their loan withdrawn.

Self-Liquidate

A simple and straightforward way to avoid being forcefully liquidated by a given lending platform is to simply pay back either all, or a portion, of the loan yourself using funds from the sale of your collateral.

While this scenario isn’t ideal, it may be the only way to avoid being liquidated for some users, and at the very least gives the individual control over how they close out their loan.

Raise Collateral

DeFi borrowing is based on a concept called the loan-to-value (LTV) ratio, which measures the amount of collateral put up versus the value of the loan taken. Common LTVs in the DeFi lending space see borrowers extract loans of anywhere between 50-75% of the value of the collateral they put up.

If the value of the collateral falls below the agreed upon ratio, the user ends up at risk of liquidation.

Therefore, if the threat of liquidation looms, DeFi users can simply increase the value of their collateral by depositing more cryptocurrency tokens. This will keep liquidation from occurring in the short-term, but may not be a viable long-term solution if the value of the collateralized assets continue to fall.

Continuously Monitor Your LTV Ratio

Liquidation can be avoided by exercising vigilance over the state of LTV ratio of a given loan. A wealth of useful tools and services exist which send real-time updates and health alerts to a borrower, informing them on the status of their loan. Of course, unless you stay awake for 24 hours of the day, you may miss the updates and get liquidated anyway.

Nevertheless, monitoring the LTV of your loan when you can is crucial given the volatility of the collateralized assets, and is a simple good-practice technique which can minimize the threat of liquidation.

Exercise Risk-Management

The primary use-case for most DeFi loans is to fund trading accounts, therefore the way an individual approaches their trades can have a major effect on the status of their loan. If they lose all of their money trading, the chances are high that their collateral will be liquidated.

Traders should exercise good risk-management by setting stop-losses, diversifying their portfolio and the direction of their trades, using pair-trading to mitigate risk, maintaining a trading journal, and taking any other steps to make sure they don’t needlessly risk their funds.

Shop Around

The threat of liquidation can be lessened substantially simply by choosing a loan product with a fairer LTV ratio – one which you won’t struggle to pay back even if the market takes a downturn.

While the margins between different LTV ratios on major DeFi platforms like Compound, Aave and MakerDAO are slim, there are still options out there for prospective DeFi borrowers.

For example, by applying a lease-contract formula to the DeFi lending process, the Nolus platform enables loans to be taken with just a small down-payment, rather than putting down 1.5 times the loan in collateral.

What’s more, unlike other DeFi lending platforms, Nolus does not liquidate all of the loan in the event of a missed payment or falling LTV ratio. Rather, the platform simply takes the next scheduled loan repayment out of the collateral until the loan is repaid.

Because Nolus allows for up to 3x leverage on its loans, users who may not otherwise have the funds to collateralize a loan can gain access to substantial DeFi loans without risking major funds.

Conclusion

There’s no getting around it: liquidation in DeFi is an ever-present risk. That being said, it can be avoided by exercising some basic safety principles and by first shopping around to find the best loan terms that align with your situation.