Mitigating Liquidation Risk With Decentralized Finance (DeFi) Loans

Borrowing using decentralized finance (DeFi) protocols has significantly grown in popularity over the past few years.

Today, billions of dollars are being borrowed from DeFi protocols on Ethereum alone. Using their crypto assets as collateral, borrowers are able to access funds for a variety of things such as large purchases, real estate, paying bills, other investments, and much more. However, given the volatility of crypto, using it as collateral for a loan can expose the borrower to liquidation risk — putting their crypto collateral in danger. How exactly does DeFi borrowing work? And what exactly is liquidation risk and how can you mitigate it so as to protect your crypto assets?

DeFi Borrowing and Liquidation

Unlike borrowing in traditional finance, borrowing in DeFi requires using 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 instance, a smart contract may allow someone to deposit crypto and earn yield or borrow crypto 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 yield on their crypto assets or borrow a variety of crypto assets such as ETH, USDC, LINK, and more. 

When you borrow from a DeFi protocol, you are first required to pledge crypto assets as collateral for your loan to the smart contract. Generally, the amount of collateral you provide must have a higher value than the amount you wish to borrow (also known as overcollateralized). Additionally, borrowers tend to pledge a different type of crypto for the collateral than the crypto they wish to borrow. This allows the borrower to maintain ownership of the crypto collateral while also increasing their leverage or getting liquidity. 

The collateral is used by the lending protocol as a form of insurance. Because there is a risk the borrower may not repay the loan, the lending protocol protects itself through holding the collateral. Additionally, if the price of the collateral asset drops significantly or if market volatility causes rapid fluctuations, the collateral's value may decline, triggering liquidation. When liquidation occurs, the lending protocol will sell the collateral and use the proceeds of the sale to repay the borrower’s debt so as to ensure they do not suffer any losses. Some protocols will also charge a fee to the borrower for liquidation as a way to both generate funds for the protocol and further disincentivize liquidation. If there is any excess funds left after the liquidation and fee, the user will be able to collect them. Through mitigating the risk of losses through liquidation, DeFi protocols create liquidation risk for the borrowers. 

How to Avoid Liquidation

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

1. Pledge significantly more collateral than required for the loan. 

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

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

If a borrower does not or cannot pledge significantly more collateral than the minimum that is required, they can continuously monitor the value of the collateral and loan to ensure they are not in risk of liquidation. If the value of their collateral drops too low, they will know and can add more collateral or repay some of the loan. However, this option is unattractive or unpractical to many due to the time and effort required. 

Is There a Better Way?

Rocko is a new platform that helps borrowers mitigate liquidation risk through sms and email alerts. Users can set up alerts to send to their phone or email based on the value of their collateral. Additionally, they’re able to customize the frequency of the alerts. For example, a user could receive an sms alert every 2 hours or email alert every 2 days whenever the specified threshold for their collateral is met. This allows users to step away from monitoring the value of the collateral and loan and instead, automatically be notified if their collateral is ever in risk of liquidation. 

In addition to customizable alerts, Rocko enables individuals to easily borrow from popular DeFi protocols like Compound using their accounts at centralized exchanges or Ethereum wallets. Users can set up their loan in minutes — without needing any DeFi expertise or a prior Ethereum wallet. Check out Rocko now!