In the last several months, liquidations have become top of the news cycle in the crypto world. This article will explain what liquidations are in the context of crypto, including how they happen and what you can do to avoid them.
What is a Crypto Liquidation?
A liquidation is the forced closing out of all or part of the initial margin position by a trader or asset lender. Liquidation occurs when a trader is unable to meet the allocation of a leveraged position and does not have enough funds to keep the trade operating.
A leveraged position refers to using your existing assets as collateral for a loan or borrowing money and then using the principal already pledged and the borrowed money to buy financial products together to make a bigger profit.
Most lending protocols, such as Aave, MakerDAO, and Abracadabra, have a liquidation function. According to Footprint Analytics data, on June 18, when the price of ETH fell, there were 13 liquidation events in the DeFi market. On the same day, lending protocols liquidated 10,208 ETH, with a liquidation amount of $424 million.
Footprint Analytics – ETH Liquidation Amount by ProtocolsFootprint Analytics – Number of ETH Liquidation by Protocols
With liquidations come liquidators. Large institutions or investors may buy the liquidated assets at a discounted price and sell them in the market to earn the difference.
Why Do Crypto Liquidations Happen?
In DeFi, stake lending is when users pledge their assets to the lending protocol in exchange for the target asset and then invest again for a second time to earn more income. It is essentially a derivative. In order to maintain the long-term stability of the system, the lending protocol will design a liquidation mechanism to reduce the risk for the protocol.
Let’s take a look at MakerDAO.
MakerDAO supports a variety of currencies such as ETH, USDC and TUSD as collateral in order to diversify the risk of the protocol assets and adjust the supply and demand of DAI. MakerDAO has established a stake rate, which is over-collateralization, of 150%. This determines the trigger for a…