Liquidation

Liquidation is a term used to describe the action of being forced to sell a position, in order to pay back a loan, or otherwise ensure that the lender can seize collateral that is as valuable as the loan. In leverage trading, liquidation occurs when a losing position threatens the ability of a borrower to repay a loan. In DeFi, liquidation is initiated by a smart contract when the loan principal is at risk. In DeFi, there are no credit checks, or recourse when making loans. This necessitates that lending follows a rules-based framework, enforced by smart contracts. 

For example, Lending protocols might allow an LTV of 65% for certain coins. If and when the leverage trading position loses upwards of 35% of value, then the collateral becomes exposed to seizure. Before this might occur, a smart-contract-enforced liquidation of the leverage trading position would enable the borrower to pay back the loan and not have the collateral seized.

As described in the Price Volatility section, leverage trading can magnify both gains and losses of a trading strategy. It’s critical to know the parameters of the protocol lending agreement before entering into a leverage trading position. Understanding haircut will help a trader know the upper bound of losses they can withstand before collateral exposure might trigger liquidation. Additionally, a trader should be well aware of the rate they are paying to borrow the leverage trading position. This will help calculate profit and loss (P&L) over the course of the trading strategy. 

Liquidations serve to enforce the terms of a loan. Because defi operates in a trustless manner, the rules and terms of a loan are programmed into the smart contracts that handle lending and trading. As a result, liquidations are price-driven and can often happen abruptly. Monitoring prices of both collateral and leverage trading position is necessary for a trader to avoid getting caught off-guard.

Liquidation is a necessary feature of smart-contract based lending agreements, as it is the enforcement mechanism to insure a leverage trader’s ability to repay a loan. Forced liquidations in large price moves tend to exacerbate the movement of the coin price in that particular direction. Generally, this is known as “shaking out” leverage. Because leverage allows for traders to expose themselves to an underlying position in greater amounts than their equity capital might otherwise afford, the selling or buying pressure in a liquidation scenario is generally magnified.