How do Liquidations Work in DeFi?

Historically, if someone were to borrow funds to purchase a car, the car would act as collateral which could be seized by the lender if the borrower were unable to repay.

Seizure of collateral (liquidation) in decentralized lending is different, as loans in DeFi are generally overcollateralized. Overcollateralized loans require more of an asset to be staked as collateral than the value of the loan taken. The amount of collateral which needs to be staked in order to obtain a loan is determined by the “loan-to-value ratio” (LTV), which is stated as a percentage.

E.g. Jane holds DAI, but wishes to take out a loan to receive 1 ETH. Jane would have to deposit more than the equivalent value of 1 ETH in DAI. If 1 ETH is valued at 3000 DAI and the required loan-to-value ratio required by the lending protocol is 75%, Jane will stake 4000 DAI as collateral.

On DeFi lending platforms, the LTV is determined by the individual platforms and will generally be different for various tokens. More volatile tokens generally have a lower LTV, meaning the user must post more collateral value to obtain a loan of a given amount.

The LTV is closely tied to the liquidation threshold, with the liquidation threshold usually being slightly higher than the LTV.

E.g. Jane’s loan has a liquidation threshold of 80%, meaning that if the value of the loan surpasses 80% of the value of the collateral, Jane’s collateral will be liquidated. Since Jane posted 4000 DAI as collateral, she needs the value of 1 ETH to stay below 3200 DAI to not cross the liquidation threshold. 

Why Total Liquidations are Bad for Borrowers

Borrowers do not want to exchange their tokens; they could simply perform a swap if so. Borrowers may be looking to obtain leverage, avoid tax obligations, or have other motivations not served by swapping their tokens.

Cryptocurrency markets can fluctuate drastically, and are not limited by a traditional market close. These fluctuations include sustained bull or bear markets, breaking news regarding an asset leading to price volatility or flash crashes. It is possible for a borrower to go to sleep and wake up completely liquidated.

Total liquidations leave borrowers unable to mitigate their losses or maintain the integrity of their loans across a period of time until repayment, as smart contracts automatically liquidate the collateral if the liquidation threshold is surpassed, even if surpassed by only a tiny amount.

Liquidations incur fees for borrowers, so the lending protocol will take more than the value of the loan in collateral. Aave, for example, charges a penalty between 4% and 10% if the loan is liquidated. This fee is deducted directly from the collateral and shared with the lender. Platforms profit when borrowers are liquidated.

What are Partial Liquidations

Partial liquidation is the gradual seizure of collateral by the lender if the borrower’s collateral changes in value relative to the loan, rather than full liquidation. Borrowers who are subject to partial liquidation will generally be appraised lower fees, as the liquidated amount is smaller, and will not have the undesirable situation of losing all of their collateral.

How Partial Liquidations Protect Borrowers

The partial liquidation feature in DeFi lending pools stops the complete loss of collateral by the borrower, as markets can be highly volatile and recover following a drop or rise in asset value.

E.g. The 1 ETH Jane borrowed had risen in price to 3250 DAI, placing her current loan-to-value ratio at 81.25%, above the 80% liquidation threshold. Instead of liquidating the whole loan, the protocol only liquidated 20% of the position. It took 650 DAI (20% of the 3250 DAI loan value) and assessed a 40 DAI fee. Jane now only has a loan for 0.8 ETH, worth 2600 DAI, and has 3310 DAI remaining in collateral, putting her current LTV at 78.5%. If the price of ETH does not rise to beyond 3310 DAI (remember: her loan is now for 0.8 ETH) then Jane will not face any further liquidations.

By having tiered partial liquidations, borrowers can have the market move against them and not lose their entire position. They may provide time for borrowers to post more collateral or reevaluate their positions while avoiding the sudden and complete consequences of total, binary liquidation.