Liquidations on blockchains

Yesterday, $237 million in collateral was liquidated from 1,222 loans using Aave, the biggest money market in decentralized finance.

Why it matters: This was the system working as designed.

• Borrowing against digital assets is the oldest function enabled in decentralized finance. The way bad loans get closed, however, helps to illuminate how DeFi finance works differently than traditional finance.

Catch up fast: When people take out a loan in DeFi, they post collateral.

• They have a ratio to maintain between the value of that collateral and what they have borrowed. Smart participants borrow much less than they are allowed, to create room for volatility.
• Yes, but: Most people don't expect the market to move quite as fast as it did this week.

By the numbers: More than half of all the collateral liquidated over the last year was liquidated Sunday through yesterday morning.

• The second worst day of the last year was April 14, when $39.7 million was liquidated.
• On most days, liquidations are in the thousands.

How it works: The many blockchains on which Aave runs are composed of smart contracts, which are used to facilitate DeFi lending.

• These global computers only run calculations when people pay them to do so. Which is why there are people (or bots, with funds attached) that function as liquidators, which are crucial to this story.

Liquidators call a function on the smart contracts, which costs money to run, that checks that the loan (the details of which are all public) has gone bad.

• If the smart contract verifies it, then the liquidator can buy out the loan (or part of it), until its collateralization ratio is adequate again.
• Each of these loans has rules for these liquidations, but it basically always works out to a bit of the collateral going to the liquidator, say 5%.

Because of the free money on the table, enough people have set up bots to watch for these situations that loans get liquidated nearly instantly upon falling below collateral minimums.

• There was something like $60 million worth of liquidation bonuses yesterday, which earned $6 million for the Aave DAO Treasury, which gets a small cut.

State of play: Decentralized finance, or DeFi, has been fairly moribund since FTX's collapse, but Aave has been rising for the last year.

• It had just regained debt levels similar to May 2022 (the Terra disaster), before this week's panic.

The big picture: Liquidations are painful for borrowers because they lose some of their collateral.

• But it isn't the system breaking. This is the system working correctly.
• To break, a DeFi money market (like Aave) would need to become insolvent. That is, it would need to have less collateral on hand than what is lent.

The bottom line: The downside of an efficient system like this is when someone borrows against an asset that can lose 20% of its value in six hours, as ether (ETH) did as Sunday turned to Monday. That collateral is never really very safe.