How can DeFi lenders protect against liquidation risk?

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Lending through decentralized finance protocols offers high rewards and high risk – Photo: Shutterstock

Decentralized finance (DeFi) loans offer potentially high rewards of more than 20% per year to cryptocurrency owners who otherwise have non-performing assets.

Owners of DeFi assets can incur debt from a protocol and use some of their crypto assets as collateral against that debt. These assets are then used to validate transactions via proof-of-stake blockchains.

Generally, the most active digital assets are used in ETH, SOL, and Matic, although other coins can also be used.

MATIC in dollars (MATIC/USD)

The best-known DeFI protocols are Aave, Compound and MakerDAO, although there are many others in the industry, with Bloomberg estimating that there were around 150 players in the market holding assets worth around $100. billion dollars at the end of January.

While the sector is currently dominated by retail players, the potential returns are attracting institutional investors.

In January, Australian DeFi player Trovio told Capital.com that major investment houses were seriously considering the sector through its Digital Asset Income Fund which promises both SOL and ETH.

Liquidation risk

Outsized returns usually come with similarly sized risks, and in the lending business, one of the biggest downsides is liquidation risk.

This risk was highlighted in January when nearly $300 million in assets across 1,000 different positions were liquidated within days, according to data from the sector tracker. Dunes, quoted by Bloomberg.

The concept of liquidation is well established in the world of conventional finance, where the assets of organizations unable to meet their debts are sold and the money raised from these sales is distributed to creditors.

But when the value of this debt reaches an agreed percentage of the value of the assets given as security for the debt, the insolvency procedure is not entrusted to a licensed practitioner as in the case of a business liquidation.

SOL in dollars (SOL/USD)

Instead, a smart contact kicks in and automatically alerts third parties to the opportunity to bid on the guarantee.

Information service provider DeFi Zapper offers the following example:

  • A user leverages ETH on MakerDAO and the current price of ETH is $1000. The user locks 10 ETH in an ETH-A vault and borrows 5,000 DAI as collateral. The ratio of outstanding debt to the value of collateral is known as the collateral ratio or c-ratio – so if the user locks in the 10 ETH ($10,000 ETH) and borrows 5,000 DAI , it has a ratio c of 200% (10,000/5,000 x 100).

  • The user gets leverage against ETH if he takes his borrowed DAI and buys ETH with it. Now they have more exposure to the ETH price, having bought five more ETH.

  • However, this means that they now have more risk if the price of ETH drops since they have debt denominated in DAI, while the collateral and the asset they bought are both in ETH.

  • If the position falls below the minimum C ratio, the underlying ETH may be auctioned off at a reduced price.

One of the most controversial aspects of the liquidation process is the incentives (sometimes called liquidation bonuses) that lending platforms offer buyers of the discounted collateral. Some of these liquidators have automated loan liquidations to speed up the process and increase their potential bonus earnings.

Of course, the market value of any asset sold at a discount will fall, which tends to lead to a sequence of events leading to further sell-offs when the panic sets in.

Ethereum to dollars (ETH/USD)

One of the reasons lenders offer substantial incentives to liquidators is the fear of being left with large amounts of assets that have fallen in value significantly if buyers pull out of the market.

Data from DeFi Explorer shows that since the January sell-off peak, relative calm has settled in the market.

From Monday January 31 to Sunday February 20, there were only four liquidations and from Monday February 28 to Sunday April 10, there was on average only one per week.

According to The Block, Rari Fuse, a DeFi lending protocol that uses assets including USDC, has been the largest source of lending market liquidations year-to-date, accounting for more than $80 million in January. and nearly all of the $23.7 million recorded in the first 20 days of April.

Nearly 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 Thursday’s crypto price crash. black in March 2020.

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USDC to dollars (USDC/USD)

So what can market participants do to minimize their exposure to liquidation? The obvious answer may be that those who interact with lending protocols maintain a relatively large buffer between the collateral and the borrowed debt, especially if the collateral is a volatile asset.

If this is not possible, applications such as DeFi Saver promise to create collateralized debt positions to borrow funds for use elsewhere, and leveraged positions in long or short supported assets in one of the built-in protocols – both with the option of liquidation protection automated.

The flurry of liquidation activity in January was exacerbated by the number of crypto users trying to outbid each other to ensure their trades were processed. The resulting volume of user traffic would have made it difficult for traders looking to cut their losses to close their positions.

DeFi loan “delta neutral”

Those considering alternative protocols might be interested to learn that solana (SOL)-based DeFi protocol Delta One announced earlier this month that it had raised over $9 million to further develop its business strategy.” neutral delta”.

In trading jargon, delta refers to changes in the value of the underlying asset.

Neutral delta is a portfolio strategy that uses multiple positions with positive and negative deltas balanced so that the overall delta of the assets in question add up to zero and the trader ends up with neutral exposure to the market.

Co-founder Paul Sengh says the protocol can’t sustain any liquidation because it’s able to rebalance a yield farmer’s position rather than having to shut it down completely.

“It’s also possible to quickly close positions when prices fall, as we have a rebalancing bot that runs multiple times per hour,” he says.

Democratize liquidation systems

Yaron Velner is CEO of B.Protocol, which claims its backstop liquidity protocol will democratize liquidation systems and shift maximum extractable value (MEV) and bot profits from liquidators to the community.

He says traders should watch their deposit collateral ratio closely and agrees with Sengh that it is usually possible to close positions before they are liquidated.

Another route uses options. For example, Cover comes as a complement to other DeFi protocols where decentralized lenders – and leveraged traders – pay a premium to protect their position with these fees used to purchase call/put options.

Sengh notes that the impermanent loss can be covered by a basket of options, although Velner is more cautious.

“Options can hedge your portfolio and reduce your losses when the price of the borrowed asset rises,” he says. “However, I wouldn’t call it liquidation protection.”

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