Liquidation is an ever-present risk in DeFi, but steps can be taken to keep that risk to an absolute minimum. Liquidation, in the context of DeFi lending, refers to a process whereby a user’s debt position is cleared using the funds they initially put up as collateral.

How this occurs varies across different platforms, but it typically happens as a result of someone not paying back their loan in the agreed-upon timeframe, or when the loan-to-value (LTV) ratio of their collateral slips below the required threshold.

Liquidations are an important part of DeFi, and help to ensure loans are repaid, but they can be a catastrophe for the borrower who may be using those funds to execute trading strategies on exchanges, DEXs, yield-farming protocols, and other DeFi dApps.

How to Avoid Liquidation in DeFi

With the above in mind, let’s take a look at some steps DeFi users can take to ensure that the risk of loans being liquidated is kept to an absolute minimum.

Utilize Health Alerts

Keeping abreast of the state of your loan is important, but the cryptocurrency market never sleeps. Anyone heavily invested in DeFi should make use of technological tools such as position health alert services, which send real-time updates on the state of your position straight to your email, Telegram, or other communication apps.

Using health alerts is a basic but crucial technique in preventing liquidation.

Use Stop-Losses 

The primary use-case for most of the borrowing that takes place in the DeFi arena is trading, an activity that has an estimated failure rate of around 95%.

Those who are using DeFi lending protocols to fund their trading positions should exercise proper risk-management by setting stop-losses on their trades, and apply other basic safety techniques to avoid losing all of their money in a single trade.

These include simple things like diversifying your portfolio, avoiding being over-leveraged, and using a trading journal to keep track of your trades.

Raise Collateral Value

Most lending is carried out using stablecoins which maintain their fiat-pegged values over time. However, the collateral that’s put up to secure these loans is typically in the form of digital tokens, which are known to be highly volatile.

For this reason, many liquidations occur not because of any fault on the part of the borrower, but simply because the value of their collateralized assets fell below the required threshold.

So a simple way for DeFi users to avoid being liquidated is to just add more collateral to their existing position. This will keep the wolves at bay in the short-term, but may only be a stop-gap solution if the value of the underlying asset continues to fall.

Self-Liquidation

If liquidation looks likely, a borrower could simply self-liquidate, or pay back, a portion of the loan using their existing collateral to bring it back in line with the agreed terms and LTV ratio.

This is a simple technique that will save users from liquidation in most cases, but naturally disrupts whatever plans the loan was being used for in the first place.

Alternatives to Liquidation

Popular DeFi lending protocols like Aave, Compound and MakerDAO will liquidate anywhere between 50% to 100% of a borrower’s position in a single go, often extracting additional fees on top for their trouble.

But the DeFi space never stops innovating, and new concepts are coming to the fore to greatly reduce the risk of liquidation and make the entire process safer for both borrowers and lenders.

The DeFi lending and borrowing platform Nolus, for example, applies a different approach by mimicking the traditional lease market. Instead of putting up between 60-100% of the loan as collateral as is normal in DeFi lending, Nolus allows loans to be secured with just a small down-payment, followed by regularly scheduled installments.

What’s more, if a loan repayment is missed, or its LTV ratio falls, Nolus simply takes the required amount out of the collateral, and never liquidates the entire position.

This lease approach to DeFi lending has some clear benefits: Nolus liquidates eight times less loans than the average lending protocol, while also enabling the use of leverage when taking loan – making capital requirements many times lower than they’d normally be.

Conclusion

DeFi lending and borrowing can be a risky endeavor, and in most cases, is beset by the possibility of instant liquidations at all times. Indeed, DeFi lending platforms recently liquidated $25 million of assets in one day due to a decline in the price of ETH.

DeFi users can exercise simple good practices to mitigate liquidation risk, such as setting stop-losses and keeping a trading journal, while also using the latest tools and services to keep up to date with the state of the market and the assets they hold.

DeFi mainstays like Aave and Compound offer a wealth of useful options when approaching lending and borrowing, but now new protocols are emerging which look to completely upend the standard model by lowering capital requirements and eradicating full liquidations.

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