Crypto lending and leveraging have become pillars of DeFi, granting users lucrative profit opportunities. Despite the inherent advantages of these permissionless protocols, however, this new frontier of finance is not without its perils.
A growing concern within web3 concerns risk – risk of liquidation, specifically. In this scenario, a user’s position is automatically closed out by the platform due to insufficient margin to cover their leveraged positions. While many people will have no sympathy for those whose positions are wiped out, viewing the exercise itself as inherently foolhardy – like scaling a perimeter fence to horse around a construction site then complaining about getting injured – the entire web3 space suffers reputationally when liquidation rates rise.
In fact, it’s no exaggeration to say that a rising tide of liquidations poses a threat to the financial stability and confidence in DeFi as a whole. So, whose responsibility is it to ensure liquidations remain at a healthy level?
The allure of high leverage in DeFi can be irresistible but it comes with heightened dangers. As a consequence of market turbulence last month, total liquidations of leveraged crypto positions in one 24-hour period surpassed $138 million. Just think about that for a second: a nine-figure sum essentially whisked out of traders’ accounts in a single day.
You don’t have to travel too far back in time to reach an even grimmer liquidation event. Back in November, bitcoin’s dip below $35k triggered liquidations totalling more than $300 million in 24 hours, affecting 77,548 traders. ‘Blood in the water’ is an understatement!
Many DeFi liquidations happen when users pledge crypto collateral to acquire a loan from a lending protocol (often to pursue a separate DeFi opportunity) and the value of the collateral falls below the liquidation threshold needed to secure the loan. Sounds simple, right? And yet in a matter of minutes a loan can be auto-liquidated and your collateral can disappear in a puff of smoke.
The risk of liquidations in crypto, of course, is exacerbated by the volatile nature of digital assets themselves. This price volatility can trigger a cascade of liquidations, often catching investors off guard. Unless you’re feverishly scanning a trading screen 24/7, you’re going to suffer at some stage.
The impact is not just individual, though: it ripples across the entire web3 landscape. When liquidations occur, it erodes trust and deters potential new market entrants, hindering the growth and sustainability of the entire space.
In many ways, DeFi platforms are driving the evolution of finance. Today, some $75 billion is locked in DeFi protocols; that figure once stood at $177 billion, and it might get back there before long. From liquid staking to lending, DEX trading to CDPs, DeFi is nothing if not innovative.
And yet, while innovation is crucial, these platforms and protocols must recognize a dual responsibility. Innovation alone isn’t enough; if they want the entire industry to maintain momentum and make good on its potential, they must actively work to minimize the risks users take on.
This doesn’t mean putting an end to liquidations, which after all are a vital element of the game. It means structuring protocols in such a way as to reduce, as much as possible, the risk of unnecessary liquidations. By better educating users on the risks, as well as strategies to minimize them, they can protect them from the pitfalls of volatility. The result? A healthier, more stable trading environment for everyone.
Such education materials shouldn’t be buried away in an FAQ either; there must be an effort to put them front and center. Moreover, protocols should commit to ensuring transparency and visibility around the mechanics of liquidation itself. Users need clear, accessible information about the dangers associated with their leveraged positions and the specific conditions that trigger a wipeout.
DeFi platforms should also implement robust risk management processes, including better collateral requirements and more responsive margin calls, to prevent unnecessary liquidations for borrowers and leverage traders.
There are other outside-the-box steps platforms can take to lower liquidation rates. The Nolus protocol, for example, takes a page out of the traditional leasing book by compelling users to pay only a small fraction upfront and gain ownership after full repayment. If much of the DeFi landscape is akin to a Wild West, Nolus seeks to restore some semblance of order.
By giving users the ability to lease up to 3x more than their equity without going down the route of unstable, over-collateralized loans, Nolus’ DeFi Lease boasts significantly lower liquidation rates than the market average. When a DeFi Lease is opened, the user’s down payment and the Nolus loan are stored in a smart contract, with both acting as collateral and the borrower terms of interest staying fixed. Importantly, users get to retain true ownership: with their underlying assets under lock-and-key until full repayment, the danger of a catastrophic liquidation is mitigated.
There are many different approaches that stand to benefit the overall Web3 ecosystem, particularly when it comes to security and privacy. But we must get control of rising liquidation rates, particularly given the outsized role played by borrowing, lending, and leveraged trading in DeFi.
By focusing on transparency, education, and effective risk management, platforms can create a more sustainable and user-friendly environment that protects individual users while enhancing the overall stability and growth of the sector. As the ecosystem continues to evolve, liquidation risk will be a key determinant of DeFi’s future.