Rising Crypto Liquidation Risks Drive DeFi to Excess
The record-breaking rout in cryptocurrencies has forced a slew of decentralised-finance
applications and their communities to race to protect themselves from
a wave of liquidations – sometimes by taking unprecedented measures.
On Sunday, token holders of Solend, a lending app on the Solana blockchain, voted to temporarily
take over a large user's account that faced liquidation, an unprecedented move for DeFi.
A day earlier, MakerDAO, a crypto community-run app that supports
stablecoin DAI and is run by one of the first decentralised autonomous organisations,
suspended the token from being deposited and minted in DeFi crypto lending platform Aave.
DeFi apps, which allow users to trade, borrow from, and lend to one another
without the use of intermediaries such as banks, are suffering because they
are often interconnected, and problems in one can have a cascading effect on others.
Tokens are frequently used as collateral to borrow a coin in one app, which is then
deposited to earn higher yields in another. When crypto prices fall, as they have recently,
margin calls on collateral can be triggered, and users who do not respond by adding more collateral
are liquidated in a process triggered by software and executed by bots designed for this purpose.
When a user is ready to be liquidated, these bots, which are run by third-party programmers
and traders, compete to liquidate the positions in order to earn a bonus, a common practise in DeFi.
As many bots compete to liquidate a position, the blockchain can become clogged with transactions.
Meanwhile, a liquidator's dump of a large number of coins can
put additional pressure on token prices, triggering another round of liquidations.
DeFi communities are attempting to avoid all of this by intervening.
"A lot of DeFi protocols are reducing counterparty
exposure during this volatile period," said Pantera Capital partner Paul Veradittakit.
The DeFi app communities are also banding together to ensure that their apps are not
harmed by things like bad debt: if a liquidator is unable to sell illiquid tokens, or if the tokens'
prices collapse while they are being sold, the apps may be held liable for reimbursements.
In the case of Solend, holders overwhelmingly supported a proposal to temporarily take over a
large user's account after the app attempted to contact the user but was unsuccessful,
bringing the threat of a massive liquidation closer.
The proposal stated that if a swarm of bots begins competing to trigger the liquidation,
"this could cause chaos, putting a strain on the Solana network."
By taking over the account, the Solend team could attempt to liquidate the position
in a way that minimises the impact on the price of the liquidated tokens,
such as through an over-the-counter sale with a specific buyer rather than on a DeFi exchange.
However, the move is highly unusual, defying DeFi norms and raising eyebrows on Crypto Twitter.
Furthermore, a single crypto address accounted for the vast majority of tokens that voted in
favour of the proposal, seemingly undermining to some the concept of "community" advocated by DeFi.
The move comes a day after MakerDAO, an app that supports stablecoin DAI,
prohibited the token from being deposited and minted in Aave's crypto lending platform due
to Aave's exposure to a troubled Ether derivative known as stETH,
which has become illiquid. Traders are unable to borrow DAI against stETH due to the suspension.
Users are debating how to reduce the risk posed by stEth on Aave's governance forum,
which DeFi risk tracker Gauntlet says "may pose additional risk to the protocol."
The pain felt by DeFi apps was triggered by the freezing of deposits by centralised crypto
lenders Celsius Network and Babel, as well as the rumoured collapse of fund Three Arrows Capital,
which sent crypto prices down in the double digits over the past seven days.
Celsius earned a lot of money by working with a lot of DeFi apps.
According to researcher Novum Insights, about 30% of all stEth stuck on Aave is from Celsius.
Meanwhile, Three Arrows Capital was an investor in Lido,
which issued stETh and is debating a governance change.
According to DeFi Llama, the total value locked in DeFi, or the amount of crypto in use on apps,
has dropped to $70.6 billion from $205.7 billion on May 5, just before the Terra
blockchain implosion triggered the year's worst crypto crisis to date.