In the dynamic world of cryptocurrency, “liquidations” play a crucial role in maintaining the ecosystem’s integrity, especially within decentralized lending and borrowing protocols. This guide aims to demystify the concept of liquidations, elucidate their significance, and detail their operational mechanism within Qonstant.
What are liquidations?
At its core, a liquidation event transpires when a “liquidator” settles a defaulted loan on behalf of a borrower, thereby earning a fee for this service. A default occurs under two primary conditions: either the borrower fails to repay the loan by its due date or fails to maintain an adequate collateral level to support their borrowed funds, rendering their account unhealthy.
An Example
Imagine a DeFi protocol that requires borrowers to have a minimum collateralization ratio of 150%. This means that for each USD 1 that someone borrows, they must have deposited at least USD 1.50 of collateral. If a borrower’s collateralization falls below 150%, their positions would be eligible for liquidation.
If a borrower owes USD 10 against USD 14 of collateral (140% collateralization), their loan is eligible to be liquidated. Assuming the protocol offers a 10% liquidation reward, a liquidator can repay the borrower’s loan of USD 10 in exchange for USD 11 (loan amount + 10% reward) of collateral. In this example, the liquidator’s profit is USD 1.
In practice, loans and collateral are denominated in different tokens, increasing complexity for both protocol operators and liquidators. Most DeFi protocols employ the use of on-chain oracles to determine the USD-equivalent value of loans and collateral to compute collateralization and facilitate liquidations.
Why does DeFi need liquidators?
Liquidations serve as a pivotal mechanism, encouraging active participation in the market to safeguard the decentralized framework of lending and borrowing. They ensure compliance with loan terms, offering a system of rewards and penalties. Liquidators receive compensation for their role in upholding protocol integrity, whereas borrowers face repercussions for not meeting their obligations. This system cleverly utilizes economic incentives to maintain anonymity and decentralization.
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How do liquidations work on Qonstant?
Liquidations at Qonstant are triggered under two circumstances:
- Non-repayment by Maturity Date: If a loan is not repaid by its designated maturity date, it becomes eligible for liquidation. Qonstant introduces a grace period post-maturity, allowing borrowers a final chance to settle their dues and avoid liquidation.
- Under-collateralization: Market fluctuations may decrease the collateral value below the borrowed amount, risking liquidation. Liquidators may then liquidate a portion of the borrow position to restore account health, with the possibility of successive liquidations if necessary. Qonstant measures collateralization via a metric called “Account Health.”
What is Account Health?
The Account Health is a measure of how close your account is to being liquidated. An Account Health below 1.0 may be liquidated at any time. Borrowers can only initiate new borrow positions with a minimum Account Health of 1.1.
The Account Health is a ratio of the account’s Collateral Factor-adjusted collateral value (in USD) divided by the Market Factor-adjusted net borrow value (in USD).
Click here for a deeper, more technical explanation of Account Health.
How can borrowers avoid liquidation?
To avoid liquidation, borrowers should vigilantly manage their loans and collateral. Timely repayments and maintaining a robust Account Health are paramount. Utilizing reminders, monitoring market trends, and adjusting collateral accordingly can significantly reduce the risk of liquidation.
Final Thoughts
Liquidations are integral to the functioning of decentralized finance, offering a balanced ecosystem for lenders and borrowers. By understanding and adhering to the guidelines provided by DApps like Qonstant, participants can navigate the crypto lending space more confidently and securely.
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