What is liquidation?

Lending and borrowing have been integral parts of the finance industry for centuries. However, in the crypto landscape, there exist some unique challenges that come with significant consequences. This article delves into one of the primary risks that borrowers face when using borrowing protocols in the DeFi space. The provision of collateral has been a longstanding tradition for those seeking loans. For instance, you can use your property as collateral to obtain a substantial loan, providing a reliable way for the lending institution to recover its money, even in cases where you default on the repayment. Essentially, your property will always be worth at least the value of the loan.

Nevertheless, this guarantee is only valid as long as the collateral maintains a stable value. In the event of a sudden drop in your property's value, the lender loses their security. Fortunately, assets used as collateral typically retain a stable enough value to prevent this from becoming a problem, but this is not always the case in the crypto world.

Crypto Collateral is at Risk

When obtaining a loan in DeFi, you must offer cryptocurrency as collateral. However, the value of crypto is highly volatile, meaning that the Ethereum or NFTs used as collateral last week could have dramatically decreased in value this week. In the event that the collateral loses its value, it becomes useless to the DeFi lender as a guarantee. It's worth noting that this issue is not exclusive to DeFi but is also present in traditional finance, as any asset can change in value. Nevertheless, the issue is more prevalent and significant in DeFi due to the inconsistent value of crypto.

While DeFi offers borrowers increased freedom, reduced bureaucracy, and fresh borrowing opportunities, it also exposes them to a higher level of risk concerning their crypto collateral. It is ultimately the borrower who bears this risk.

DeFi Risks for Lenders

DeFi places all the risk on the borrower, but the high volatility of crypto poses a more significant risk for lending protocols. It's not desirable for a lending protocol to end up with collateral assets that they can't sell because there's always a possibility that nobody will be interested in buying those assets. As a result, the protocol might be unable to recover their loan.

To overcome this challenge, protocols usually auction off liquidated assets at a value lower than their market worth. In DeFi, third parties are allowed to "bid" on the assets to enable a quick sale. This "race to the bottom" has an adverse impact on the overall value of the currency or collection.

In summary, the management of liquidation in DeFi is not only risky for borrowers, but it also has significant consequences for lenders and the currency as a whole. This unique marketplace is something to consider when seeking to borrow in DeFi.

How to avoid liquidation risk

When the collateral is volatile (as it is in crypto), it's advisable to maintain a healthy margin between your collateral and the asset you're borrowing. In case the market moves, you can increase the value of your collateral by adding more collateral assets or repaying the loan to prevent liquidation.

DeFi is a unique ecosystem with its regulations and risks, which cannot be changed. However, you can protect yourself by learning how the system works. Learning how to interpret a smart contract is an excellent starting point as it allows you to examine the protocols you're using and their terms.

Similarly, using a wallet that provides maximum transparency when interacting with smart contracts will help you understand the terms you agree to every time you engage with them.

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