Navigating the Risks of Automatic Liquidation in DeFi
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Chapter 1: Understanding Automatic Liquidation
If you are venturing into high-risk strategies involving 30x leveraged positions, or engaging in Ethereum lending to acquire stablecoins for further investments in trending tokens, you may soon encounter the harsh reality of automatic liquidation. This scenario arises when the price movement of a token pushes your loan-to-value ratio into a precarious zone, often referred to as being under-collateralized.
This guide aims to shed light on the process of automatic liquidation employed by lending platforms to keep your account solvent. We'll also discuss how to repay your debts to avoid falling victim to this phenomenon.
Key Topics Covered:
- Mechanics of automatic liquidation on platforms like Aave
- Strategies for repaying debts on Aave
- Understanding Aave's variable debt tokens
- The minting and burning of tokens
- A quick overview of smart contracts
Tools You Will Need:
- A spreadsheet tool (e.g., Google Sheets)
- Aave (a lending and borrowing platform on Ethereum)
- Arbitrum (our selected layer 2 solution for this guide)
- Arbiscan (a blockchain explorer for assessing fees and contract interactions on Arbitrum)
- A web wallet such as Metamask
Let’s take a moment to reflect on a fundamental truth often overlooked in the Web3 and DeFi communities: any leveraged position you take on must eventually be settled. This principle holds true in traditional finance as well—whether it’s mortgages, car loans, or credit cards, all involve leveraging your financial capacity.
Unfortunately, many individuals do not fully grasp the importance of debt repayment. Perhaps it’s a lack of concern or an optimistic belief that their investments will yield returns exceeding their debt obligations. This mindset may explain why a significant portion of high-income Americans are living paycheck to paycheck.
Key Statistics:
- Total U.S. consumer debt stands at a staggering $16 trillion.
- Household savings rates have plummeted to below 5%.
- The S&P 500 index has declined by 17% year-to-date.
The dream of a decentralized financial utopia, free from the constraints of traditional banking, feels increasingly out of reach. In just the last 24 hours, the Ethereum Network has liquidated $52 million in leveraged positions.
Chapter 2: The Mechanics of Automatic Liquidation
In this video, we explore how bankruptcy courts are influencing cryptocurrency law and the implications for investors.
The allure of smart contracts within decentralized finance is that there is no bankruptcy court to turn to. Here, code reigns supreme, and your agreements are etched into immutable transactions governed by smart contracts. If you find yourself liquidated due to breaches in systematic risk parameters, the process is automatic—there are no judges or trials.
Let’s illustrate this with an example using 100 staked Ethereum (stETH). Suppose you deposit $600,000 worth of stETH at a price of $6,000 per token, allowing you to borrow up to 82.5% of that amount in USDC, or $495,000.
The loan-to-value (LTV) ratio is crucial here. If Ethereum’s value drops by just 3%, from $6,000 to $5,800, your LTV exceeds the liquidation threshold, leading to potential liquidation. For instance, if the price plummets to $1,400, significant losses could ensue.
It's important to note that when borrowing assets like USDC against staked Ethereum, the value of your debt is measured in Ethereum terms, complicating matters when market fluctuations occur.
Now, let's consider the implications of a health factor below 1, which indicates an imminent liquidation. If Ethereum’s price falls to $5,800, your position may be liquidated automatically.
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To maintain solvency, platforms like Aave enforce liquidation penalties on top of the initial liquidation event. Liquidators can pay off up to 50% of the loan to restore the health factor above 1, while receiving a 5% incentive for their efforts.
Understanding these dynamics is essential for anyone participating in DeFi. The processes underpinning liquidation and debt repayment are embedded in smart contracts, and they operate without the possibility for intervention or negotiation.
Chapter 3: Strategies for Debt Repayment
Paying back your debt on Aave is a straightforward process. Here’s how you can do it:
- Visit aave.com.
- Click the "Repay" button.
- Approve the transaction.
- Confirm your repayment.
As you navigate these transactions, keep in mind that the variables surrounding your debt can change rapidly.
To summarize, this guide not only instructs you on the repayment process but also emphasizes the importance of understanding how lending platforms issue ERC20 tokens that represent both collateral and debt.
Your journey through DeFi can be rewarding, but it’s crucial to recognize the inherent risks of automatic liquidation and how platforms like Aave manage solvency.
You've been warned.
John Cook
September 22nd, 2022
San Francisco, CA
www.frontruncrypto.com
Supporting Resources:
- Arbiscan transaction details used for this guide
- Aave ConsenSys protocol overview
- Aave risk parameters and penalties
- Aave developer documentation
Quote of the Week: “I asked an AI program what it thought about financial markets this year.” — Reddit