Key Points

  • Over the last few years, millions of dollars worth collateralized assets have been liquidated in decentralized finance (DeFi). While most of them occurred daily, others with larger liquidations happened in waves.
  • The greatest of such events is the Black Thursday that happened on Thursday, March 12, 2020, where a total of 399 liquidations occurred in MarkerDAO with over $10 million worth of collateralized assets liquidated on the same day alone. The crash resulted in $550,000 worth of liquidations on Aave and $5 million on Compound.
  • Given that these scenarios do not happen often, it is of utmost importance that crypto enthusiasts understand how liquidations happen in popular DeFi lending and borrowing protocols, and these events can be prevented.
  • This guide highlights the process of liquidations in the Aave protocol and how they can be minimized or prevented.

What is Liquidation?

In finance, liquidation is the process where a business ends and its assets to claimants are disrupted. In some cases, it occurs when a company becomes insolvent and cannot meet up with its relevant obligations.

In the case of lending and borrowing protocols, liquidation is a process that occurs when the value of a borrower’s collateral depreciates in comparison to the value of a loan. It often happens when the collateral decreases in value or a borrower’s debt increases in value against each other, that is, when a borrower’s health factor goes below 1.

The collateral vs loan value ratio is often shown in the health factor. During the process of liquidation, up to 50% of a borrower’s loan is repaid and the addition of that value and liquidation fee is taken from the collateral available. Therefore, after liquidation, the amount liquidated from the debt is repaid.

Just as with loans, providing collateral has been an existing norm for borrowers. For instance, if a borrower needs a significant amount of loan, the individual is often asked to provide collateral such as a house or any other landed property which will give the lending institution a way of recovering their money from the borrower in the event that the loan cannot be repaid.

In reality, the lending institution only has this guarantee provided that the collateral itself is maintained at a steady value. If the value of the collateral crashes, the lender would lose the security of the collateral. Normally, assets used for collateral maintain somewhat of a steady price so the issue is rare.

It is entirely different with crypto as collaterals face greater risk and volatility.

Taking loans in DeFi requires providing crypto collateral, the volatility notwithstanding. Borrowers often experience a higher degree of freedom and new borrowing opportunities with DeFi. However, it is important to note that it poses a higher degree of risk which is often borne by the borrower. The value of Ethereum or AVAX used as collateral today may completely change next week, causing the collateral to fall in value and taking security away from the lender. It is not unusual for collateral to fall in value, however, it is more pronounced in DeFi protocols due to the volatility of crypto assets.

How Liquidations Occur on Aave

The collateralization ratio is one of the most important factors in Aave liquidations. The system considers the liquidation point and each collateral type has a minimum collateralization ratio. Once your position falls below the minimum collateralization ratio, the position in the vault will get liquidated.

In Aave, once a borrower’s position falls below 50%, it can be bitten at a time without any form of auction. This means a single person can liquidate an unsafe position and win the collateral at a specific discount rate.

There are certain factors associated with liquidations on Aave:

  • The liquidation penalty often varies based on the type of assets and ranges from 5 to 15%. ETH is specifically pegged at 5%, and this is lower compared to some protocols such as Compound and MakerDAO.
  • Recently, Aave introduced a safety leeway called the liquidity on top of the maximum loan-to-value ratio. This ratio varies between assets. In a situation where a borrower reaches 100% of their borrowing power, they automatically would not be able to borrow any more funds. However, such users will have some room left until liquidation occurs.
  • With Aave, an interface exists where uncollateralized positions can be liquidated right in the application.

Below are some notable figures concerning liquidations on Aave (the following numbers are made up for simplicity):

  • Symbol: Aave
  • Loan to value: 50%
  • Liquidation threshold: 65%
  • Liquidation bonus: 10%

The following is an example of an Aave liquidations:

  • Ann deposits 12 ETH and borrows 6 ETH worth of USDC. 
  • If Ann’s Health Factor drops below 1 her loan will be eligible for liquidation. 
  • A liquidator can repay up to 50% of a single borrowed amount, that is 3 ETH worth of USDC. 
  • In return, the liquidator can claim a single collateral which is ETH (5% bonus).  
  • The liquidator claims 3 + 0.15 ETH for repaying 3 ETH worth of USDC

How to Overcome Liquidations on Aave

Overcoming liquidation involves doing two basic things. To instantly make a position safer the borrower can either add more of the supplied collateral or repay a part of the debt. If a borrower does any of these, their collateralization ratio increases and debt power is reduced. More often than not, the major way borrowers prevent liquidation in the Aave ecosystem is by repaying a part of the debt to unwind their position and reduce their debt.

It is important to understand that the impact of these strategies depends on the collateral rules behind each asset and each protocol.

Repaying to Unwind position and Reduce Debt.

As one of the major Ethereum DeFi protocols, Aave has become increasingly popular and is often used by DeFi traders as a mechanism for leverage when taking short or long positions with certain assets. The scenario involves the option of paying back debt with an already supplied collateral. 

By completely or partially repaying borrowed assets, users can unwind their existing positions. The Repay feature works in both Aave, MakerDAO, and Compound, and can be found in their respective dashboards in DeFi saver.

The Repay option in one transaction does three things:

  • Withdrawal of supplied collateral (e.g ETH)
  • Swapping supplied collateral for the borrowed asset (e.g exchanging ETH for UDDC)
  • Using the new funds to repay debt (e.g repaying UsDC debt).

In Aave, Repay can be used with any pair of borrowed assets. When borrowers keep their health factor above 2, it gives them more of a margin to avoid being liquidated. 

There are two unique tools that can help with this. The HAL tool enables borrowers to track and receive notifications about their health factor (HF). Secondly, DeFi Saver helps users auto-liquidate their loans.

Borrowers should even pay attention to fluctuations in the prices of stablecoins that are being used as collateral. For instance, in the rare occurrence that USDC falls below $1.00, the borrower’s health factor would be impacted.

Frequently Asked Questions

Can you get liquidated on Aave?

Yes, anybody can get liquidated on Aave, provided they are taking out loans and providing collateral. In the case of liquidators, these traders often develop their own solutions and bots to become the fastest in liquidating loans and receive a liquidation bonus.

How can I participate in Aave liquidation?

Anyone can participate in Aave liquidation by:

  • Using the liquidations module in the Aave app
  • By calling the liquidation call directly in the lending pool contract.

What is the liquidation threshold in Aave?

The Aave liquidation threshold is the percentage at which a loan is defined as undercollateralized. This depends on the asset in question. For instance, if the Aave token liquidation threshold was 75%, it would mean that when Aave’s value rises above 75% of the collateral, the loan is undercollateralized and is under threat of liquidation.

How much is Aave’s liquidation penalty?

The liquidation penalty, sometimes regarded as liquidation bonus, often varies depending on the asset used as collateral. Borrowers can find every assets’ liquidation fee in the risk parameters section.

What is the benefit of borrowing from Aave?

When investors borrow from Aave, they are able to obtain a working capital without selling their assets. Most times, users borrow for unexpected expenses, leveraging their holdings, or for new investment opportunities.

What is a good health factor for Aave?

A good health factor for Aave liquidation is above 1.