About DeFi Liquidation: Understanding, Risk and Management

Decentralised Finance or DeFi is changing how people interact with the financial landscape, offering users to lend or trade financial activities without relying on banks or other traditional intermediaries. One important aspect of this system is liquidation, which occurs when a user's collateral fails to meet the required level set by the lending protocol. Here we explained in detail in this blog post, including its workings and the effects it has on ecosystem users. Anyone attempting to navigate the DeFi space must have a solid understanding of liquidation since it has a big influence on risk management and investing methods. 

About DeFi Liquidation

DeFi liquidation happens when a borrower's collateral value in a lending protocol drops below a certain amount, called the liquidation threshold.  The protocol will then automatically sell or auction the collateral to pay off the loan and keep the platform solvent.  Unlike traditional banking, smart contracts are used to carry out this operation promptly and without human interaction.  The fundamental volatility of cryptocurrency prices, which can lead to sharp fluctuations in collateral values, is the primary reason for liquidations. 

Understanding of DeFi Liquidation

Let's imagine you pledged your valuable cryptocurrency as collateral when you started a loan agreement on a lending protocol.  The protocol will automatically liquidate your agreement and auction off your collateral for less than its worth if the market value of that cryptocurrency drops below a certain point, known as the liquidation threshold.  You lose your collateral because the market determined it was worth less, not because you were unable to repay.  In DeFi, the market controls the participant. 

The Risk of Crypto Collateral

Initiating a borrowing deal in DeFi requires supplying cryptocurrency as collateral.  Because of the volatility of cryptocurrencies, the collateral's value might fluctuate dramatically in a short amount of time.  The DeFi lender can no longer use the collateral as a guarantee if its value declines.  The participant is at more risk because they run the risk of losing their collateral. 

Lenders' DeFi Risks

Lenders may also be at risk from DeFi.  Lending protocols are at greater risk due to the volatility of cryptocurrencies.  There is a chance that no one will wish to purchase the assets if a participant's collateral is liquidated, which would prevent the protocol from recovering their agreement.  Protocols will auction off liquidated assets below their worth to counteract this, enabling third parties to bid on the assets for a speedy sale. 

Risks Associated with Liquidation

Users involved in DeFi lending and borrowing are exposed to a number of dangers during liquidation events. For risk management and investing strategies to be effective, it is imperative to comprehend these risks. The major risk is the possible loss of collateral, which market volatility might make worse. Liquidation fines can also be imposed on users, significantly reducing their assets. Due to the automated nature of liquidations, users might not be able to take action if their collateral is in danger. Some of the notable risks include:

• Substantial financial loss as a result of the liquidation of collateral.
• Unexpected changes in the market that cause quick liquidations.
• The possibility of asset sales during liquidation is slipping.
• Restricted options if a liquidation has taken place.
• Market panic and emotional strain amid erratic times.

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How to manage Risk of Liquidation

Effective risk management is important for all DeFi members. The following are some important best practices:

• Track Collateralization Ratios: Keep an eye on the threshold and health factor of your loan.
• Use Alerts: Configure automated alerts for price fluctuations or the impending liquidation of your stake.
• Keep a buffer: To withstand price fluctuations, keep your collateralization far beyond the bare minimum.
• Recognise the Liquidation Penalty: If your position is liquidated, be aware of the associated consequences. 

Conclusion

DeFi liquidation is a fundamental concept that all members of the DeFi ecosystem should know because liquidations are automated and decentralised, they can have a big financial impact on debtors; therefore, risk management is crucial.  Users can traverse the DeFi landscape with more assurance if they comprehend how liquidations operate, the mechanisms that cause them, and the preventative measures to take.  Participating successfully in the DeFi space will require being knowledgeable and flexible as it continues to change.