Most DeFi apps require traders to overcollateralize, however -- effectively taking out less in loans than they put in.
Driving Down the Price
A trader may find out that others could get liquidated when a coin’s price drops to, say, $100. The trader could then build up a sufficient position in the coin, then sell in order to pull the price below $100, while also collecting the reward for liquidating the trader that most DeFi apps offer.
“Most protocols offer a 10-15% liquidation fee,” Omakase said. “Triggering enough liquidations would cause a liquidation cascade where a motivated actor could simply hold a short position in order to profit for the subsequent secondary decrease.”
Other traders are simply profiting off liquidations they don’t trigger. Nathan Worsley runs a slew of bots -- software programs -- that search for traders who are about to get liquidated and gets paid a commission for liquidating them.
“Recently the amount of liquidations has been huge,” Worsley said in emails. “However, liquidations is not a continuous strategy, you sometimes go for a week or more without any significant liquidations. However, when liquidations happen there are usually a lot at once. You basically have to work a long time while making $0 profit, in order to be ready for the big day or two when you might be able to make a million dollars at once.”
His bots continuously scour blockchains, keeping a list of all the borrowers using a particular app and scrutinizing the health of their accounts. Once positions are ready for liquidation, “it’s usually a battle to be the quickest and perform the liquidation,” Worsley explained.
“I would push back on classifying this as an ‘attack,’” he added. “The reason is because without liquidations, you can’t have a lending market. So even though no one enjoys being liquidated, it’s essential that people do get liquidated in order to make the market and protect the protocol from insolvency.”
Liquidations can be triggered after traders borrow from apps like Aave or Compound, and put up collateral -- say, in Ether -- that’s typically greater than what they borrow, perhaps 120% of the borrowed funds. If Ether’s price drops, that collateral may now be worth only 110% of what the trader borrowed.
‘Protect the Protocol’
“My job as the liquidator is to protect the protocol by closing your position,” Worsley said. “The protocol gives me a reward for being a liquidator to encourage this activity, because blockchains cannot move by themselves. You have borrowed $1,000 of Bitcoin, so I repay the $1,000 of Bitcoin you owe the protocol. In return, the protocol gives me $1000 of your Ethereum collateral, plus a $100 ‘liquidation bonus’ from your excess collateral. I have made a profit, you have been liquidated and your position is closed, and the protocol itself has been protected from bad debt.”
With liquidation targets becoming more and more tempting in a tumultuous market, Omakase offers this advice: “Generally everyone should stay safe, everyone should avoid the use of leverage.”