IDEAS home Printed from https://ideas.repec.org/p/arx/papers/2212.07306.html
   My bibliography  Save this paper

Toxic Liquidation Spirals

Author

Listed:
  • Jakub Warmuz
  • Amit Chaudhary
  • Daniele Pinna

Abstract

On November 22nd 2022, the lending platform AAVE v2 (on Ethereum) incurred bad debt resulting from a major liquidation event involving a single user who had borrowed close to \$40M of CRV tokens using USDC as collateral. This incident has prompted the Aave community to consider changes to its liquidation threshold, and limitations on the number of illiquid coins that can be borrowed on the platform. In this paper, we argue that the bad debt incurred by AAVE was not due to excess volatility in CRV/USDC price activity on that day, but rather a fundamental flaw in the liquidation logic which triggered a toxic liquidation spiral on the platform. We note that this flaw, which is shared by a number of major DeFi lending markets, can be easily overcome with simple changes to the incentives driving liquidations. We claim that halting all liquidations once a user's loan-to-value (LTV) ratio surpasses a certain threshold value can prevent future toxic liquidation spirals and offer substantial improvement in the bad debt that a lending market can expect to incur. Furthermore, we strongly argue that protocols should enact dynamic liquidation incentives and closing factor policies moving forward for optimal management of protocol risk.

Suggested Citation

  • Jakub Warmuz & Amit Chaudhary & Daniele Pinna, 2022. "Toxic Liquidation Spirals," Papers 2212.07306, arXiv.org, revised Jan 2023.
    • Handle: RePEc:arx:papers:2212.07306
    as

    Download full text from publisher

    File URL: http://arxiv.org/pdf/2212.07306
    File Function: Latest version
    Download Restriction: no
    ---><---

    References listed on IDEAS

    as
    1. Amit Chaudhary & Daniele Pinna, 2022. "A multi-asset, agent-based approach applied to DeFi lending protocol modelling," Papers 2211.08870, arXiv.org, revised Dec 2022.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.

      More about this item

      NEP fields

      This paper has been announced in the following NEP Reports:

      Statistics

      Access and download statistics

      Corrections

      All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:arx:papers:2212.07306. See general information about how to correct material in RePEc.

      If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

      If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

      If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

      For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: arXiv administrators (email available below). General contact details of provider: http://arxiv.org/ .

      Please note that corrections may take a couple of weeks to filter through the various RePEc services.

      IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.