DeFi liquidations: hidden forces that ensure solvency of the system

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Lending is the second largest sector in DeFi space, with more than $18.79 billion worth of TLV locked across 159 different protocols as of Aug 2022. In July last month, the borrowing volumes were sitting at $5.1 billion, even during the worst bearish market cycle that we are currently witnessing. 

During the second quarter of 2022, we saw many CeFi (Centralised Finance) companies like Celsius, BlockFi, and Voyager going either bankrupt or insolvent, with more than $26 billion assets under management combined, forcing customer withdrawals overnight. 

However, DeFi worked flawlessly 24×7, despite the bad macro conditions. Celsius was forced to pay down its $400M DeFi loans on Maker, Aave, and Compound to prevent its collateral from being liquidated.

How do DeFi protocols ensure solvency of the system? 

DeFi leverages a process called the liquidations, which is handled by the liquidators.

DeFi loans are over-collateralised. Liquidations in lending protocols occur when a borrower’s position becomes under-collateralised, and this may occur when the price of a borrowed asset increases and so reduces the comparative value of collateral backing of the borrowing, or the price of collateralised assets fall. 

External Liquidators – The traditional way of handling liquidations

Just like miners in a Proof of Work system and validator nodes in a Proof of Stake system, external liquidators are entities that are incentivised to keep the entire system functioning and solvent. 

External Liquidators individually maintain bots to scan lending protocols and identify under-collateralised borrower positions and buy those positions at a discount that ranges anywhere between 5% to 15%. 

One of the issues with this design is that a borrower’s position is almost always over-liquidated beyond the amount required to return the borrower’s position to solvency. This happens because a liquidation needs to be economically viable for liquidators. 

Minterest Innovation – Automated Liquidation

Instead of relying on external liquidators, Minterest protocol itself undertakes the liquidator role and that directly benefits the borrowers, as algorithms do not require economic incentives to participate in the liquidation processes. 

The protocol is therefore able to economically liquidate significantly smaller percentages of borrower collateral which results in a more equitable and fairer liquidation process. 

Liquidators play an important role in the DeFi ecosystem to keep the system solvent, and they are economically incentivised to do so. Minterest is bringing new innovations in the space with its automated liquidation engine to directly benefit the borrowers and remove reliance on third-party counterparties.