Research Review of An Empirical Study of DeFi Liquidations: Incentives, Risks, and Instabilities

Explore the intricacies of DeFi liquidations in our in-depth analysis of Ethereum’s lending market mechanisms, revealing the impact on borrowers and liquidators, and offering insights into potential financial system improvements.

In the rapidly evolving world of decentralized finance (DeFi), lending market dynamics are intriguing and complex. The study titled “An Empirical Study of DeFi Liquidations: Incentives, Risks, and Instabilities,” by Kaihua Qin and colleagues (October 2021), sheds light on this area, particularly on the topic of liquidations within the Ethereum DeFi ecosystem​​.

The research addresses the significant gap in quantitative insights about DeFi liquidation mechanisms. Focusing on major DeFi platforms like Aave, Compound, MakerDAO, and dYdX, which comprise over 85% of Ethereum’s lending market, the study comprehensively analyzes liquidation processes. These platforms have accumulated $39.88 billion in Total Value Locked (TVL), underlining their substantial impact on the DeFi sector​​.

Key Findings:

1. Liquidation Mechanisms: MakerDAO uses an auction-based liquidation process, whereas Aave, Compound, and dYdX utilize a fixed-spread liquidation model​​.
2. Data Analytics: Over two years, the study observed 28,138 liquidation events, totaling $807.46 million. It highlighted issues like ‘bad debts’ in platforms like Aave V2 and demonstrated the market’s sensitivity to significant price fluctuations​​.
3. Liquidation Mechanism Comparison: The research reveals that fixed-spread liquidation mechanisms disproportionately favor liquidators over borrowers, often leading to excessive collateral liquidation​​.
4. Optimal Fixed Spread Liquidation Strategy: An innovative strategy is proposed to enhance liquidators’ profits by lifting restrictions on the amount of debt repaid in a single liquidation. However, this strategy could exacerbate borrowers’ losses​​.

Auction-Based Liquidation Explained (MakerDAO):

• Process: When a loan becomes under-collateralized (i.e., the value of the collateral falls below a certain threshold), MakerDAO initiates an auction process.
• Functioning: Interested parties (liquidators) bid on the collateral by offering to pay off a part of the debt in exchange for the collateral. This is typically done in a descending-price (Dutch) auction format.
• Goal: To get the best possible price for the collateral, minimize the borrower’s loss, and ensure the platform’s stability.

Fixed Spread Liquidation Explained (Aave, Compound, dYdX):

• Process: This model activates when a loan reaches under-collateralization, similar to the auction-based model.
• Mechanism: Instead of an auction, the collateral is sold at a fixed discount (known as the ‘liquidation spread’) to the market price. This discount is predetermined and known to all participants.
• Rapid Execution: This model allows for quicker liquidation as it doesn’t involve a bidding process. Liquidators can instantly purchase the collateral at this discounted rate.
• Impact: The fixed spread model is generally faster and less complex but may not always fetch the best possible price for the collateral, potentially leading to higher losses for the borrower.

The study’s strength lies in its detailed empirical approach, providing a rare quantitative view into the DeFi liquidation landscape. Its extensive data analytics offer invaluable insights into the behaviors and outcomes of different liquidation strategies.

However, there are limitations and potential biases. While understandable, given their market share, the focus on Ethereum-based platforms may not encapsulate the full spectrum of the DeFi ecosystem. Additionally, the study’s timeframe (two years) may not be sufficient to capture the long-term trends and implications of these liquidation mechanisms.

Arguably, the most surprising aspect is the proposed optimal fixed-spread liquidation strategy. This strategy, designed to maximize liquidators’ profits, starkly reveals the potential for systemic imbalances where liquidators can significantly benefit at the expense of borrowers​​.

The study’s findings are crucial for understanding the risks and incentives in DeFi lending markets. They highlight the need for better-balancing mechanisms between liquidators and borrowers, potentially guiding future protocol designs and regulatory considerations. The insights could spur innovation in developing more equitable and stable DeFi lending platforms.

This research makes a significant contribution to understanding DeFi liquidations. It provides a thorough analysis of current practices and points towards the need for improved mechanisms to ensure fairer outcomes for all participants in the DeFi space. As the DeFi ecosystem continues to evolve, studies like this are vital in guiding its sustainable and equitable growth.