Liquidators Headline the DeFi Show
Black Thursday (March 12, 2020) will be remembered as the day that brought the largest stress test to the ‘modern’ DeFi ecosystem.
The story? Liquidations. $25m of collateral was liquidated across the leading DeFi lending protocols — Maker, Compound, and dYdX —in just the last month. Roughly $10m of that amount was liquidated on a single day on March 12 , with a majority of liquidations in ETH.
Collateral Liquidated
as of March 15, 2020
Collateral Ratio
as of March 15, 2020
Record Liquidations on Compound and dYdX
On March 8, The Block reported that Compound had its (then) largest day of liquidations ~$2.53m. Just four days later, Compound saw roughly $6.26m in liquidations — a new record. When users’ debt on Compound becomes undercollateralised, anyone can liquidate. Liquidators get a 5% discount incentive on liquidated assets.
“I think it’s mainly because they [Compound] have a more aggressive collateral ratio. And the incentives are higher to liquidate there because you get paid immediately instead of entering an auction” — Gauntlet Networks CEO Tarun Chitra
dYdX trailed Compound with the second highest number of liquidations ~$4.88m. Liquidators on dYdX are similarly able to purchase collateral from the borrower at a 5% discount. Remarkably, the platform maintained a safe collateralization ratio and also hit a single day record trading $45m in 24hrs [1]. Compound also remained solvent throughout the series of cascading liquidations.
Faulty Maker Vault Liquidations
MakerDAO, another mainstay of the DeFi ecosystem, told a slightly different story through the chaos — revealing structural flaws of the collateralisation system in need of improvement for when the system is stress tested to a similar degree (if not worse) once again. Anyone can use Maker to open a Collateralized Debt Position (CDP), lock ETH as collateral, and generate Dai as debt against that collateral [2]. Over the 24hr period starting March 12, ETH dropped a whopping -47%. Since Maker leverages ETH for overcollateralization, the price shock put significant downward pressure on DAI (borrowing demand for DAI shot through the roof) and resulted in severely undercollateralised positions, among other issues. The total amount worth of liquidated DAI is estimated to be around $4.5 million. According to MakerDAO, the market chaos allowed liquidators (called Keepers*) to bid close to 0 Dai for batches of 50 ETH collateral forcing a number of Vault liquidations through failed/uncompetitive collateral auctions.
Marc Zeller from Aave wrote a great article on Building the Post-Liquidation Era, in which he argued for the emergence of more robust self liquidation services to prevent a similar MakerDAO liquidation situation from happening in the future. He points to the use of flash loans, which allowed the say ‘fortunate’ ones to self-liquidate and avoid the total loss of their collateral positions on MakerDAO, for example. Effectively, users were able to use an application called DeFi Saver to utilize liquidity from Aave Protocol’s lending pools to instantly pay back their CDP debt and take out all collateral, using the required part to pay back the flash loan and walk away with the remaining ETH [7]. Zeller proposes that the availability of stop-loss services in DeFi could also help to mitigate collateral losses/liquidation penalties in the future.
In their post-Black Thursday reflection, MakerDAO acknowledged that there was an opportunity for numerous Keepers to participate in auctions and keep the system stable [3]. Unlike in Compound or dYdX, where liquidators receive a fixed discount on the collateral, MakerDAO employs a full collateral auction in Multi-Collateral Dai (MCD) whereby a “minimum bid increment” guarantees Keepers some gap between true market price and the price paid in auction [4]. Effectively the more Keepers there are, the safer/more robust MakerDAO is.
Maker Backstop Liquidation Syndicate
Prior to the downturn on March 12, MakerDAO had a surplus of $500,000; now they are faced with a negative surplus of $5.6m that needs to be filled.
MakerDAO plans to sell MKR tokens in exchange for DAI in a real time auction coming up on March 18. The auction will programmatically create and sell off MKR tokens in 50,000 DAI increments and use the capital acquired to pay off outstanding bad debt [5].
According to MakerDAO, the idea is to create a pooled contract that would give syndicate participants a way to participate in the auction process should MKR fall below a given price [6]. The intention is for the syndicate to purely function as a backstop liquidity provider.
The Future of Liquidations: Sole Liquidator or Liquidation Pool?
To cooperate or not to cooperate? That is the question.
Tom Schmidt from Dragonfly Capital Research describes the so-called life of a liquidator in his article:
Though liquidations vary in mechanism and terms across protocols, they fundamentally require the same components:
| a bot that monitors pending Ethereum transactions and looks for loans that are eligible for liquidation
| a decentralized exchange that can be used to instantly sell the liquidated collateral and guarantee a profit for the liquidator
| a smart contract that allows the liquidation and sale of the collateral to occur atomically in one transaction KeeperDAO
The challenge for every liquidator is that there can only be one winning transaction for every liquidation opportunity. The more capital a liquidator has, the higher the likelihood she can make a profit; although margins for liquidations are expected to compress overtime with growing technical advancements around automated CDP management and other self-liquidation services. For the purposes of this article, I assess the current state of the liquidator market. Given technical challenges (running liquidation bots) and the associated capital constraints, joining a smart contract pool may be an attractive alternative.
KeeperDAO, a joint project between Ren Protocol and Amber Group, is a smart contract pool which enables users to pool capital into Ethereum smart contracts to collectively profit from on-chain arbitrage and liquidation opportunities. (Disclaimer: I am the Head of Institutional Sales at Amber Group).As an on-chain liquidity underwriter, KeeperDAO aims to solve the issues currently associated with capturing these on-chain liquidation opportunities: capital inefficiency and gas costs. According to the KeeperDAO team, by having a large pool of liquidity, KeeperDAO is able to capture opportunities much larger than what could be captured by individuals. Liquidators will always be able to get a share of larger opportunities by using the KeeperDAO liquidity pool, opportunities that they could not necessarily capture by themselves [8]. Since arbitrage trades are pure revenue opportunities, the key is to pay more in gas costs than the next person. If someone outbids KeeperDAO transactions in gas, KeeperDAO will submit a new transaction to the point where there is theoretically no profit left for anyone. Basically creating an all or nothing outcome.
You might also be wondering whether it is worth putting your funds in an ‘idle’ pool of capital. In fact, thanks to Ethereum’s composability property, joining such a liquidity pool can also expose users to further income earning opportunities. KeeperDAO explains that to mitigate sitting on a large pool of underutilized capital, the protocol would effectively rehypothecate the pool of staked capital on Compound and dYdX to earn interest for participants. To learn more about the mechanics of the KeeperDAO protocol, I encourage you to read through this post here and listen to the recent Blockcrunch Podcast on The Secret Whales of DeFi.
It would be an understatement to say that the market gave DeFi participants a lesson last week. Thanks to the system’s Keepers, the ecosystem didn’t completely fall apart. Chaos exposes flaws and a market downturn such as the one we just experienced showed just how much more work is needed to build a solid foundation for an otherwise jenga-prone DeFi market structure. The next stress test may sing a different tune but make no mistake, liquidations will continue to happen.
Borrowers beware, else Keepers will take your lunch and eat it too 🍽
*A Keeper is an independent (usually automated) actor that is incentivized by arbitrage opportunities to provide liquidity in various aspects of a decentralized system. In the Maker Protocol, Keepers are market participants that help Dai maintain its Target Price ($1): they sell Dai when the market price is above the Target Price, and buy Dai when the market price is below the Target Price. Keepers participate in Surplus Auctions, Debt Auctions, and Collateral Auctions when Maker Vaults are liquidated.(www.makerdao.com)
This article is for information only and must not be considered financial advice. Unless cited, views are my own and not that of Amber Group.
Sources
[1] https://twitter.com/ashwinrz/status/1238942130233643010?s=20
[2] https://defipulse.com/maker
[3] https://blog.makerdao.com/recent-market-activity-and-next-steps/
[4] Schmidt, Tom. (2020) Liquidators: The Secret Whales Helping Defi Function https://medium.com/dragonfly-research/liquidators-the-secret-whales-helping-defi-function-acf132fbea5e
[5] Leading Ethereum-based Decentralized Finance Credit Facility, MakerDAO, is Planning to Conduct MKR Governance Token Auction https://receive.news/03/14/2020/defi-leading-ethereum-based-decentralized-finance-credit-facility-makerdao-is-planning-to-conduct-mkr-governance-token-auction/
[6] https://twitter.com/defipulse/status/1238578830476021760?s=20
[7] Zeller, Mark. (2020) Building the post-liquidation era https://medium.com/aave/building-the-post-liquidation-era-4e650935fc88
[8] Zhang, Taiyang. (2019) Introducing KeeperDAO, an on-chain liquidity underwriter https://medium.com/keeperdao/introducing-keeperdao-an-on-chain-liquidity-underwriter-dbb63731f4a5
