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Liquidations: DeFi on a Knife-edge

Author

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  • Daniel Perez
  • Sam M. Werner
  • Jiahua Xu
  • Benjamin Livshits

Abstract

The trustless nature of permissionless blockchains renders overcollateralization a key safety component relied upon by decentralized finance (DeFi) protocols. Nonetheless, factors such as price volatility may undermine this mechanism. In order to protect protocols from suffering losses, undercollateralized positions can be liquidated. In this paper, we present the first in-depth empirical analysis of liquidations on protocols for loanable funds (PLFs). We examine Compound, one of the most widely used PLFs, for a period starting from its conception to September 2020. We analyze participants' behavior and risk-appetite in particular, to elucidate recent developments in the dynamics of the protocol. Furthermore, we assess how this has changed with a modification in Compound's incentive structure and show that variations of only 3% in an asset's dollar price can result in over 10m USD becoming liquidable. To further understand the implications of this, we investigate the efficiency of liquidators. We find that liquidators' efficiency has improved significantly over time, with currently over 70% of liquidable positions being immediately liquidated. Lastly, we provide a discussion on how a false sense of security fostered by a misconception of the stability of non-custodial stablecoins, increases the overall liquidation risk faced by Compound participants.

Suggested Citation

  • Daniel Perez & Sam M. Werner & Jiahua Xu & Benjamin Livshits, 2020. "Liquidations: DeFi on a Knife-edge," Papers 2009.13235, arXiv.org, revised Dec 2021.
    • Handle: RePEc:arx:papers:2009.13235
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    References listed on IDEAS

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    1. Sam M. Werner & Paul J. Pritz & Daniel Perez, 2020. "Step on the Gas? A Better Approach for Recommending the Ethereum Gas Price," Springer Proceedings in Business and Economics, in: Panos Pardalos & Ilias Kotsireas & Yike Guo & William Knottenbelt (ed.), Mathematical Research for Blockchain Economy, pages 161-177, Springer.
    2. Lewis Gudgeon & Sam M. Werner & Daniel Perez & William J. Knottenbelt, 2020. "DeFi Protocols for Loanable Funds: Interest Rates, Liquidity and Market Efficiency," Papers 2006.13922, arXiv.org, revised Oct 2020.
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    Cited by:

    1. Jiahua Xu & Krzysztof Paruch & Simon Cousaert & Yebo Feng, 2021. "SoK: Decentralized Exchanges (DEX) with Automated Market Maker (AMM) Protocols," Papers 2103.12732, arXiv.org, revised Mar 2023.
    2. Bertomeu, Jeremy & Martin, Xiumin & Sall, Ibrahima, 2024. "Measuring DeFi risk," Finance Research Letters, Elsevier, vol. 63(C).
    3. Jiahua Xu & Nikhil Vadgama, 2021. "From banks to DeFi: the evolution of the lending market," Papers 2104.00970, arXiv.org, revised Dec 2022.
    4. Kaihua Qin & Liyi Zhou & Pablo Gamito & Philipp Jovanovic & Arthur Gervais, 2021. "An Empirical Study of DeFi Liquidations: Incentives, Risks, and Instabilities," Papers 2106.06389, arXiv.org, revised Oct 2021.
    5. Massimo Bartoletti & James Hsin-yu Chiang & Alberto Lluch-Lafuente, 2020. "SoK: Lending Pools in Decentralized Finance," Papers 2012.13230, arXiv.org.
    6. Jiahua Xu & Yebo Feng, 2022. "Reap the Harvest on Blockchain: A Survey of Yield Farming Protocols," Papers 2210.04194, arXiv.org, revised Dec 2022.
    7. Simon Cousaert & Jiahua Xu & Toshiko Matsui, 2021. "SoK: Yield Aggregators in DeFi," Papers 2105.13891, arXiv.org, revised Mar 2022.
    8. Estelle Sterrett & Waylon Jepsen & Evan Kim, 2022. "Replicating Portfolios: Constructing Permissionless Derivatives," Papers 2205.09890, arXiv.org, revised Jun 2022.
    9. Lioba Heimbach & Eric G. Schertenleib & Roger Wattenhofer, 2023. "Short Squeeze in DeFi Lending Market: Decentralization in Jeopardy?," Papers 2302.04068, arXiv.org, revised Jun 2023.

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