Mitigating Liquidation Risk with Decentralized Finance (DeFi) Lending

Borrowing using decentralized finance (DeFi) protocols has grown significantly in popularity in recent years.

Today, billions of dollars are borrowed from DeFi protocols on Ethereum alone. By using their crypto assets as collateral, borrowers can access funds for a variety of things such as major purchases, real estate, bill payments, other investments, and much more. However, given the volatility of cryptocurrencies, using them as collateral for a loan can expose the borrower to liquidation risk, putting their crypto collateral at risk. How exactly does DeFi borrowing work? And what is liquidation risk and how can you mitigate it in order to protect your crypto assets?

DeFi Borrowings and Liquidations

Unlike borrowing in traditional finance, borrowing in DeFi requires the use of a DeFi protocol which is a set of smart contracts deployed on a public blockchain such as Ethereum. Smart contracts are code-based, self-executing agreements. For example, a smart contract can allow someone to deposit cryptocurrencies and earn a yield or borrow cryptocurrencies at a specific rate, all based on predefined logic. Compound and Aave are two of the most popular DeFi protocols deployed on Ethereum and allow users to earn a yield on their crypto assets or borrow a variety of crypto assets such as ETH, USDC, LINK, etc.

When borrowing from a DeFi protocol, you must first pledge crypto assets as collateral for your loan to the smart contract. Typically, the amount of collateral you provide must be worth more than the amount you wish to borrow (also known as overcollateralization). Additionally, borrowers tend to pledge a different type of cryptocurrency than the cryptocurrency they wish to borrow. This allows the borrower to retain ownership of the crypto collateral while increasing leverage or gaining liquidity.

Collateral is used by the lending protocol as a form of insurance. Since there is a risk that the borrower will not repay the loan, the lending protocol protects itself by holding the collateral. Additionally, if the price of the collateral asset drops significantly or market volatility causes rapid swings, the value of the collateral may drop, triggering a liquidation. When liquidation occurs, the lending protocol will sell the collateral and use the proceeds to repay the borrower’s debt to ensure that they do not incur any losses. Some protocols will also charge the borrower a fee for liquidation to generate funds for the protocol and further discourage liquidation. If there are excess funds left after liquidation and fees, the user will be able to reclaim them. By mitigating the risk of losses through liquidation, DeFi protocols create liquidation risk for borrowers.

How to avoid liquidation

Most DeFi protocols set explicit liquidation thresholds based on the value of the loan relative to the value of the collateral. This allows borrowers to mitigate liquidation risk through two common methods:

1. Offer guarantees significantly higher than those required for the loan.

Since liquidation only occurs if the value of the borrower’s collateral drops too much, borrowers can pledge collateral that is significantly higher than the minimum required for the loan. This gives them more leeway, so it would take a larger drop in the value of their collateral for liquidation to occur. However, this reduces the effectiveness of the borrower’s crypto and limits the amount they can borrow.

2. Continuously monitor the value of the collateral and the loan.

If a borrower cannot or cannot provide collateral significantly above the minimum required, they can continually monitor the value of the collateral and the loan to ensure they are not at risk of liquidation. If the value of their collateral falls too low, they will know and can add more collateral or repay part of the loan. However, this option is unattractive or impractical for many because of the time and effort involved.

Is there a better solution?

Rock is a new platform that helps borrowers mitigate liquidation risk through SMS and email alerts. Users can set up alerts to be sent to their phone or email based on the value of their collateral. Additionally, they can customize the frequency of alerts. For example, a user can receive an SMS alert every 2 hours or an email alert every 2 days once the specified threshold for their collateral is reached. This allows users to stop monitoring the value of their collateral and loan and be automatically notified if their collateral is at risk of liquidation.

In addition to customizable alerts, Rocko makes it easy for individuals to borrow from popular DeFi protocols like Compound using their accounts on centralized exchanges or Ethereum wallets. Users can set up their loan in minutes, without the need for any DeFi expertise or an Ethereum wallet. Discover Rocko now!

Disclaimer: The information contained herein is provided without taking into account your personal circumstances and should not be construed as financial advice, investment recommendations, or an offer or solicitation for transactions in cryptocurrencies.

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