Detailed explanation of the liquidation mechanism of the lending platform How to avoid risks and improve capital efficiency?

A friend called and cried to me: He was having a good time borrowing and mining. After being busy for three days, I did not open the platform and found that I had been liquidated.

Due to the occurrence of this incident, I think it is very necessary to explain a problem that many people overlook and make many people headaches in DeFi lending: the liquidation mechanism.

This article aims to answer the following questions:

What is the mortgage rate?

Is the maximum safety value safe?

Why did I set the loan within the maximum safety value or was liquidated?

How to reduce liquidation risk and improve capital utilization efficiency?

There are currently many lending platforms, such as Compound and AAVE on the Ethereum mainnet, and the lending platform on the Huobi ecological chain Heco. The basic liquidation logic of each lending platform is the same, but the mortgage rate is different, so I will use the lending platform on Heco as an example.

Mortgage rate and liquidation

The DeFi lending platform can be regarded as a bank. For example, the mortgaged property borrows from the bank, the estimated value is 10 million, and the actual loan (for example) 6.5 million, a few days after the house has fallen by 35%, it is worth 6.5 million, then this asset is yours If you don’t make up the money, you can liquidate and sell it now-this is insolvency, bankruptcy and liquidation.

For the same reason, the DeFi lending platform is the same and more clear. Take a lending platform on Heco as an example (code C platform). The USDT mortgage rate stipulated on the C platform is 80%, which means that if you deposit 10,000 USDT, you can borrow up to 8,000 USDT equivalent of encrypted assets, such as 8,000 US dollars of BTC or 8000 USDT or 8000 HUSD.

For different platforms, the mortgage rate for different currencies may be different. For example, on the L platform on Heco, the USDT mortgage rate is 90% instead of 80%.

Once the mortgage rate is exceeded, it may be liquidated.

For example, if you deposit 10,000 US dollars, lend 8,000 US dollars of Bitcoin, and then Bitcoin rises a little, you should be liquidated theoretically. That is, insolvency.

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The relationship between mortgage rate and liquidation is both yin and yang, and the maximum mortgage rate will be liquidated. This is not to say that the assets of the people being liquidated, if they are not liquidated, the entire platform will be insolvent, and the normal borrowing of others will also be affected. Therefore, a liquidation mechanism must be in place to make the system work well. After the assets are liquidated, for you, they are completely gone.

Maximum safety, usage rate, risk value

Take the C platform as an example, the USDT pledge rate is 80%, and the safe maximum platform defaults to 80%. If you 10000 USDT, deposit it, and if you lend USDT or other encrypted assets (btc, eth, etc.) according to the safe maximum, it is 1 Ten thousand*80%*80%=6400 USD.

Because the “used” and “risk value” here refer to the proportion of the funds you can lend to the funds you lent. How much money can you lend to the C platform? You can borrow 80%, that is, you can borrow up to 8,000 US dollars. At this time, if you loan 4,000 US dollars, then “used” is 4000÷8000=50%, and your “used” is 50%. Instead of displaying as 40%.

Is the safety maximum safe?

The answer is that in some cases it is very safe and in some cases it is very unsafe. We continue to explain.

When borrowing and lending are all stable coins

If the deposit is a stable currency such as USDT, the loan is a stable currency (it can be usdt or HUSD, DAI, etc.). Due to the stable price, the fluctuation is often within 1%, and the maximum is 5%. Then, the maximum safety value is of course very safe. In order to improve the efficiency of funds, you can even lend out 90% of the “pledge rate”. In other words, in this case, you deposit 10,000 US dollars and lend 9,000 US dollars, there is no problem.

Fluctuations in borrowing and lending assets

For example, if you deposit 10,000 U.S. dollars and lend 6,400 U.S. dollars of BTC according to the “safe maximum value”, then the “safe maximum value” is also very unsafe. You only need to increase the price of 6,400 U.S. dollars in BTC to 8,000 U.S. dollars, and your assets will be Will be liquidated. Or conversely, you deposited 10,000 US dollars in Bitcoin and lent 6,400 US dollars in USDT. If the BTC price drops to 6,400 U.S. dollars ÷ 80% = 8,000 U.S. dollars, Bitcoin worth 10,000 U.S. dollars is now worth 8,000 U.S. dollars. Your assets will also be liquidated.

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In this case, it is recommended that the total assets to be loaned should not exceed 50% or 40%. For example, if you deposit usdt, BTC, ETH, etc., and the total value is 10,000 US dollars, you can borrow 4,000 US dollars of encrypted assets. Check it every day. If the short-term value of the loaned assets doubles, it is not a big problem. Many people tend to lend only 30% of their assets for insurance.

When borrowing and lending are in the same currency

In this case, it is mostly because of participating in loan mining. Depositing 1 btc with the highest loan pledge rate is 0.8 BTC. You said that the price of the two is the same. I can lend 100% of the assets that can be loaned, which is 0.8 BTC, absolutely not. Still liquidated. The reason is that the borrowed interest is often higher than the borrowed interest (not including the platform currency rewards for borrowing and mining), and this depositary borrowing interest is all currency-based. Soon, the value of the lent assets is higher than the mortgage rate (80%) of the value of the borrowed assets, and the liquidation begins.

But if you use the maximum safety value with caution (the settings for each platform are also different), or it is larger than the maximum safety value, there is no problem. Taking platform C as an example, deposit 1 BTC, the mortgage rate is 80%, and the safe maximum value for lending is 80%. At this time, you can lend out 0.64 BTC, and there is no problem even if you lend out more than the safe maximum. For example, you can lend 90% of all funds lent is 1BTC*80%*90%=0.72BTC. The problem is not big. Because it is the same currency, the logic is like “borrowing and lending are all stable currencies”.

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Note: The mortgage rate of each platform is different, and the mortgage rate of different currencies on each platform is also different. Be sure to read the relevant liquidation rules document of the platform before participating in the lending platform.

to sum up

It is necessary to calculate clearly when using a lending platform. If the price fluctuations between borrowing and lending currencies are large, you need to adopt a prudent strategy. It is best to go to the platform to check the ratios displayed on the “risk value”, “used”, etc., at this time ” The “safe maximum value” is not safe, and the lending rate should be lowered; if the price fluctuations between borrowed and lending currencies are not large, such as single currency borrowing and lending or stable currency borrowing and lending, the so-called “safe maximum value” can be exceeded . According to different situations, the basic logic of risk and capital utilization efficiency is these.

Author/ Translator: Jamie Kim
Bio: Jamie Kim is a technology journalist. Raised in Hong Kong and always vocal at heart. She aims to share her expertise with the readers at Kim is a Bitcoin maximalist who believes with unwavering conviction that Bitcoin is the only cryptocurrency – in fact, currency – worth caring about.