The Risks of Liquidation and Tips for Safe Borrowing Practices
Liquidators serve an important role in keeping a lending network healthy and preventing the creation of bad debt. They ensure that there are always enough funds in a lending network to support the open positions. Having said that, users should be wary of getting liquidated and take necessary precautions to prevent it.
Liquidation is the process of repaying a borrower's debt on their behalf, in exchange for a portion of their collateral. In a healthy lending network, liquidators are incentivized to constantly look for loans eligible for liquidation. The process is as follows:
- 1.The value of a position changes past the liquidation threshold, so a signal indicates that it's now eligible for liquidation
- 2.A liquidator comes in and repays a portion of the loan on behalf of the borrower
- 3.After repaying the borrowed amount, the liquidator receives a portion of the collateral proportional to the amount they paid off, plus the Liquidation Incentive
A position can get liquidated when it's under-collateralized, meaning there is no longer enough collateral to support the amount that has been borrowed. The Liquidation Factor - expressed as a percentage - is a multiplier used to calculate the value at which these liquidations can occur.
Say a user deposits ETH and it has a Liquidation Factor of 80%. This means that when the value of the borrowed position reaches 80% of the supplied ETH value, a liquidation can occur.
Each token in a lending network has its own Liquidation Factor, as determined by the creator.
Two price movements can move a position closer to liquidation, and it's important to pay attention to both to know when a loan must be adjusted:
- 1.The value of the collateral token falls
- 2.The value of the borrowed token increases
Let’s look at an example of both cases:
- 1.A user deposits 1 ETH as collateral when 1 ETH = $1000 USD, and uses it to borrow $400 DAI. Let's assume ETH has a Liquidation Factor of 80%, meaning the liquidation point occurs when the value of the borrowed asset equals $800. If one month later, the price of ETH falls to 1 ETH = $500, the new liquidation point is $400 (80% x $500). If the user didn't adjust their initial loan, they will be at risk of getting liquidated.
- 2.A user deposits $1000 DAI as collateral and uses it to borrow 0.5 ETH when 1 ETH = $1000 USD. Let's assume DAI has a Liquidation Factor of 75%, meaning the liquidation point occurs when the value of the borrowed asset equals $750. If one month later, the price of ETH rises to 1 ETH = $1500 USD, the value of the borrowed tokens has increased to $750 USD (0.5 ETH x $1500 USD), thus making the position eligible for liquidation.
In Ola's lending networks, the amount of a position that can be liquidated at one time is set at 50% (ie. the Close Factor). This means that only part of the borrower's debt is repaid and not all of it.
Let's assume a position in which you have deposited $1,000 in DAI and borrowed $400 in ETH is eligible for liquidation. Assume the Liquidation Incentive for DAI is 10%.
A liquidator will come and pay on your behalf up to $200 in ETH (50% of what you borrowed). In return, the liquidator will get $220 of your DAI: $200 DAI + $20 DAI for the Liquidation Incentive.
Your new position after the liquidation: Deposit Value - $780 in DAI, Borrow Value - $200 in ETH
You can view the Liquidation Incentives for each asset by clicking on the asset in the "Network" tab of the app.
The best way to protect yourself against liquidations is to understand how, why, and when they occur. After reading this page, here are some additional tips that can be used to help decrease the likelihood of liquidations:
- 1.Don't Borrow the Maximum Amount: There is usually a buffer between the Collateral Factor and the Liquidation Factor, but you can offer yourself more of a buffer by not borrowing the maximum amount.
- 2.Use a Stablecoin to Lend/Borrow: As we learned, positions can change due to price movements in both the supplied asset and the borrowed asset. By using a stablecoin for one side, you reduce the number of variables you have to monitor.
- 3.Monitor Your Position: After initiating a position, make sure to check on it frequently to ensure it remains in good health.
- 4.Have a Repayment Plan: The longer you have a loan out, the more chance there is for liquidation. Although loans through Ola's lending networks have no required repayment date, it's smart to have a plan to repay your loan before taking it.
The only way to fully prevent liquidations is to keep the value of your collateral worth sufficiently more than your loans. If you followed the safe borrowing tips and are still at risk of liquidation, two measures can be taken:
Pay Back Your Loan. The recommended way to avoid liquidations is to pay back at least a portion of the amount you have borrowed.
Deposit More Collateral. By supplying more collateral to a lending network, you decrease your loan to value ratio (LTV). For example, borrowing $700 against $1000 of collateral is using 70%, but borrowing $700 against $2000 collateral is using 35%. You can deposit more of the same asset, or a different one available in that same lending network. If using multiple forms of collateral, keep in mind that each has its own Liquidation Factor.