As the DeFi leverage landscape continuously evolves, one mechanism remains a cornerstone: liquidation. Traditionally rooted in over-collateralization, this process is experiencing a seismic shift with the introduction of undercollateralized leverage. At Arkis, we’re at the helm of this transformation, offering a unique approach that diversifies the established norms.
This article will unpack the process of liquidation across various DeFi platforms, and highlight how Arkis stands out with our innovative adoption of undercollateralized leverage. By reshaping liquidation mechanisms, we aim to foster flexibility and security, allowing our users to navigate the DeFi ecosystem with confidence and ease. Let’s delve into this paradigm shift and discover how Arkis is redefining liquidation in the DeFi landscape.
What is liquidation?
Liquidation refers to the process by which collateral is seized to repay a debt when the value of that collateral falls below a certain level, which is specified by the terms of the loan agreement.
When users borrow assets on a platform, they are required to overcollateralize their loans, meaning they must provide collateral that exceeds the value of what they are borrowing. This is to ensure that the lender is protected against potential market volatility.
If the value of the collateral falls significantly due to market fluctuations, it can reach a point where it’s no longer sufficient to cover the value of the borrowed assets. This point is typically referred to as the liquidation ratio or liquidation threshold.
When the value of the collateral hits this threshold, the DeFi protocol will automatically trigger a liquidation event. The collateral will be sold off (or “liquidated”) to ensure that the debt is repaid.
In many DeFi protocols, this liquidation process is performed by other users of the platform, known as liquidators, who are incentivized to participate through earning liquidation bonuses or fees. This is a critical mechanism in DeFi lending platforms to manage risk and ensure the system remains solvent.
What is forced liquidation?
Forced liquidation is a mechanism employed by platforms that offer leveraged trading, where the platform automatically sells, or “liquidates,” a trader’s collateral when the value of that collateral falls below a certain threshold. This threshold is usually determined by the level of leverage used and the volatility of the collateral asset.
Leveraged trading refers to the practice of using borrowed funds to amplify potential returns from a trade. While this can increase profits if the trade is successful, it also magnifies potential losses if the trade doesn’t go as planned.
Here’s why forced liquidation is necessary:
- Risk Management: Forced liquidation is a crucial risk management tool that helps ensure the solvency of DeFi protocols. Without this mechanism, a sudden drop in the value of the collateral could result in losses for the lenders, as the collateral might no longer cover the borrowed amount.
- Automated and Trustless: In traditional finance, the lender might negotiate with the borrower or initiate a lengthy legal process in the event of a default. However, in DeFi, processes are automated and trustless. Thus, forced liquidation happens automatically without the need for intermediaries, in line with DeFi’s ethos of decentralization and automation.
- Market Efficiency: By ensuring that loans are always sufficiently collateralized, forced liquidations contribute to the overall health and efficiency of the market. They help maintain the balance between borrowers and lenders and preserve confidence in the platform.
However, forced liquidations also pose a risk to traders who might lose their collateral if the market moves against them. Therefore, traders need to be mindful of their collateralization ratios and the inherent risks associated with leveraged trading.
Comparative Analysis: Liquidation across Platforms
Each DeFi protocol has its unique method of handling liquidation, shaped by its individual structure and offerings. Understanding these differences is key to making informed decisions when interacting with these platforms. In this section, we’ll take a closer look at the liquidation processes of notable platforms and exchanges like Binance and Aave, providing you with a comprehensive overview of their distinct strategies and the implications for users.
Binance
Binance, one of the largest and most popular cryptocurrency exchanges globally, offers a variety of services, including a robust platform for leveraged trading.
In Binance’s futures markets, traders can open leveraged positions, which means they can borrow additional funds to potentially amplify their returns. However, trading with leverage also magnifies potential losses, and this is where the liquidation process comes into play.
When a trader opens a leveraged position on Binance, they must provide collateral to secure the borrowed funds. If the market moves against the trader’s position, the value of their collateral decreases. Should the collateral’s value drop to a certain level — known as the maintenance margin — the trader’s position is at risk of being liquidated.
Liquidation on Binance is an automated process. When a trader’s position reaches the maintenance margin level, Binance will close the position and use the remaining collateral to repay the borrowed funds. The purpose of this process is to ensure that the borrowed funds are always repaid, protecting the interests of the lender and maintaining the overall health of the market.
Aave
Aave, a decentralized non-custodial money market protocol, offers a different approach to liquidation compared to centralized platforms like Binance. In Aave, users can lend and borrow a variety of cryptocurrencies. To borrow assets, users must provide collateral in excess of the loan value, hence overcollateralization is the norm, providing a buffer against price volatility.
However, if the value of the collateral falls significantly due to market fluctuations, it might no longer sufficiently cover the loan value. This situation prompts what is known as a liquidation event.
Aave’s liquidation process is a bit different compared to traditional finance or centralized exchanges. When the health factor of a loan (a measure of the safety of the loan relative to the collateral) falls below 1, the loan becomes subject to liquidation. At this point, anyone can repay up to 50% of the outstanding debt on behalf of the borrower and in return, they receive a portion of the collateral equivalent to the repaid debt plus a liquidation bonus. This incentivizes prompt repayment and helps maintain the overall health of the Aave ecosystem.
The liquidation bonus ranges from 5% to 15% depending on the asset, and is used as an incentive for liquidators. The bonus, combined with the ability to purchase collateral at a discounted price, encourages rapid response from liquidators, helping to ensure the system remains solvent.
The potential challenge lies in the fact that while users are incentivized to facilitate liquidation, they are not mandated to do so. This could potentially lead to situations where a debt remains unliquidated, simply due to the absence of any parties willing to initiate the liquidation process.
In essence, Aave’s liquidation process helps balance the interests of borrowers and lenders, keeping the ecosystem robust and stable. However, it also highlights the importance of monitoring one’s positions closely and maintaining a healthy collateral ratio to avoid liquidation.
Liquidation on Arkis
Arkis Protocol does not rely on external liquidators like most protocols do.
Rather, Arkis uses DEXs to convert traders’ portfolios into borrowed assets. For each asset in a trader’s portfolio, Arkis uses the Liquidation Routing table (see below) which defines which portion of the asset is converted to the corresponding borrowed asset on a certain DEX. Arkis uses several DEXs in liquidation to minimize market impact.
The liquidation process is described below:
When the Risk Factor drops below 1, all open orders are canceled, and Margin Account assets are no longer available to a trader. 5 steps happen to liquidate the position.
- Close liquidity pools and staking positions: All liquidity pools, lending, staking, and farming positions are closed, and fees are claimed.
- Define liquidation routing: For each token that needs to be converted into a borrowed asset, we use Liquidation DEXs, where a position will be liquidated.
- Bridging: If tokens are located on a chain other than a reference exchange, Arkis Protocol uses bridges to transfer assets to the corresponding chains where Liquidation DEXs operate.
- Liquidation: Tokens are swapped for the borrowed asset on each reference exchange taking into account the weight of each exchange in Liquidation Routing.
- Return funds into Arkis Liquidity Pool: Funds are returned to a liquidity pool used to fund the leveraged position. If the liquidity pool is located on a different chain — funds are bridged first to the designated chain.
Wrapping up
The liquidation process plays a pivotal role in the world of DeFi leverage. While each platform, from Binance to Aave, has its unique approach to liquidation, all share the common goal of balancing risk and reward, maintaining system solvency, and ultimately, ensuring the continued trust of their users.
However, the landscape is shifting, and at Arkis Finance, we’re proud to be at the forefront of this change with our innovative undercollateralized leverage model. While this approach brings its own challenges, it also holds the potential for greater flexibility and accessibility for users.
The world of DeFi is complex and ever-evolving, with each innovation building upon the last. As we continue to push the boundaries of what’s possible, we’re committed to keeping you informed and empowered in your DeFi journey. The future of finance is decentralized, and together, we are shaping it. Whether you’re an institutional investor or an individual, our mission remains the same: to help you navigate this landscape with confidence, flexibility, and security. So keep exploring, stay informed, and welcome to the future of finance.
About Arkis
Arkis — DeFi Prime Broker offers multichain, undercollateralized leverage powered by portfolio margin. Author Oleksandr Proskurin is the Co-founder and Chief Product Officer.
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