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Register a new userAn Empirical Study of DeFi Liquidations: Incentives, Risks, and Instabilities
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Financial speculators often seek to increase their potential gains with leverage. Debt is a popular form of leverage, and with over 39.88B USD of total value locked (TVL), the Decentralized Finance (DeFi) lending markets are thriving. Debts, however, entail the risks of liquidation, the process of selling the debt collateral at a discount to liquidators. Nevertheless, few quantitative insights are known about the existing liquidation mechanisms. In this paper, to the best of our knowledge, we are the first to study the breadth of the borrowing and lending markets of the Ethereum DeFi ecosystem. We focus on Aave, Compound, MakerDAO, and dYdX, which collectively represent over 85% of the lending market on Ethereum. Given extensive liquidation data measurements and insights, we systematize the prevalent liquidation mechanisms and are the first to provide a methodology to compare them objectively. We find that the existing liquidation designs well incentivize liquidators but sell excessive amounts of discounted collateral at the borrowers expenses. We measure various risks that liquidation participants are exposed to and quantify the instabilities of existing lending protocols. Moreover, we propose an optimal strategy that allows liquidators to increase their liquidation profit, which may aggravate the loss of borrowers.
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The trustless nature of permissionless blockchains renders overcollateralization a key safety component relied upon by decentralized finance (DeFi) protocols. Nonetheless, factors such as price volatility may undermine this mechanism. In order to protect protocols from suffering losses, undercollateralized positions can be liquidated. In this paper, we present the first in-depth empirical analysis of liquidations on protocols for loanable funds (PLFs). We examine Compound, one of the most widely used PLFs, for a period starting from its conception to September 2020. We analyze participants behavior and risk-appetite in particular, to elucidate recent developments in the dynamics of the protocol. Furthermore, we assess how this has changed with a modification in Compounds incentive structure and show that variations of only 3% in an assets dollar price can result in over 10m USD becoming liquidable. To further understand the implications of this, we investigate the efficiency of liquidators. We find that liquidators efficiency has improved significantly over time, with currently over 70% of liquidable positions being immediately liquidated. Lastly, we provide a discussion on how a false sense of security fostered by a misconception of the stability of non-custodial stablecoins, increases the overall liquidation risk faced by Compound participants.
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