In DeFi, liquidations are a critical event that occur when a loan becomes undercollateralised, i.e. when the value of the deposited collateral (or security) drops below a given threshold. This is a severely negative outcome for the borrower. Aside from amplified price swings, liquidations are one of the major risks associated with leveraging a position via borrowing.
Due to the volatile nature of many cryptocurrencies, liquidations are common in DeFi; especially during market crashes. They act as a way to protect lenders from the risk of losing their capital when borrowers make significant losses.
In DeFi, borrowers are currently required to overcollateralise their loans, resulting in a collateralisation ratio (CR) which is > 1. This means that the value of the deposited collateral is greater than the borrowed amount. This collateral will be liquidated (automatically sold) in order to pay back the lender, if the loan to value ratio, or LTV is reached.
LTV serves as an indicator of how risky a loan the lender is ready to offer. It is the ratio between the loan amount offered, and the required value of collateral.
For example, a cryptocurrency lending platform may assign ETH an LTV ratio of 80%, meaning that by using $1,000 of ETH as collateral, a user could borrow up to $800 of another currency, such as DAI. This results in an initial CR of 1.25, but this should be regularly monitored to ensure the loan’s CR remains above the minimum allowed.
In this example, the collateral is a volatile asset (ETH) and the loan is a stablecoin (DAI). If the price of ETH were to drop below the loan’s liquidation threshold, the loan is considered undercollateralised and is subject to liquidation.
At this point, the platform makes the loan available to liquidators (usually automated bots), who return the borrowed amount to the lender and buy the collateral at a discount, pocketing the difference as payment for their service. In the above example, upon liquidation the borrower would lose their $1,000 of ETH and be left with the $800 of DAI borrowed. This is potentially the worst outcome for the borrower, who in addition to the $200 loss, would ideally like to make use of their loan while still holding onto their deposited collateral.
There are various ways to minimise the risk of liquidation when borrowing cryptocurrencies, including monitoring and maintaining a high CR (which can be topped up with further collateral deposits if necessary), using stablecoins (either as collateral or the borrowed asset, or both), or using assets with lower volatility.