Comment by polynomial
3 years ago
Can you explain what you mean by crypto's forced liquidation rules? Not familiar with how that works at all.
3 years ago
Can you explain what you mean by crypto's forced liquidation rules? Not familiar with how that works at all.
As the other comment says, liquidation in tradfi has manual intervention - the loans will say things like "IF the collateral mark-to-market value drops below $X, the lender MAY call the loan and force sale of the collateral" - the key being the IF.
In a case where there's contagion [549] the banks or even the government can work to negotiate what's happening, and slow down the collapse (or even prevent it) - an example being the subprime mortgage backed securities which got to the point that nobody knew how to value them, so the government bought them all (and eventually actually "made" money by riding it out).
DEFI has algorithms that lock up the capital and will automatically liquidate it if certain parameters are met - which others can use to "attack" it - if the oracle sees bitcoin fall below $20k in a flash crash, it triggers the selling of ten thousand coins, say, which floods the price down further, you snap them up, the crash is over, you slowly sell at $25k or whatever. Bitcoin itself is pretty resistant to this, but the other coins, not so much, especially the side coins.
As a side note, most US home loans do NOT have a "call" clause and the bank can only initiate liquidation after you've missed payments and gone delinquent for a certain number of days; this was instituted in the US after calling mortgages contributed to the Great Depression. Some business loans can be called after a period of time for any reason (usually, interest rates have gone up).
[549]: https://en.wikipedia.org/wiki/Financial_contagion
When you get margin called in traditional/centralized finance, humans intervene and liquidation is not immediate (except Interactive Brokers, who are closer to how crypto manages margin, and will liquidate you without a margin call). Maybe you put up more collateral, maybe you borrow from a line of credit, there is a buffer. As an individual, you work with your broker. As a larger participant, you work with the clearinghouse (of meme stock fame).
In crypto, there is no buffer. Auto liquidation of undercollateralized positions occurs. All of those humans in the loop, “unfair rules”, and settlement delays crypto proponents complain about are the very things that make traditional finance stable. This is why traditional finance doesn’t take seriously the idea of immediate settlement, and why end of day settlement is as good as it’ll get.
> In crypto, there is no buffer. Auto liquidation of undercollateralized positions occurs. All of those humans in the loop, “unfair rules”, and settlement delays crypto proponents complain about are the very things that make traditional finance stable.
Is auto-liquidation a bad thing? It leads to more volatility in the short-term, but it seems that there might be long-term benefits of ensuring that players with unresponsible business practices will be forced out of the market.
"Traditional" crypto holders will be affected too (the value of their investment goes down while people are forced to sell), but this looks more like a temporary impact. As long as they don't trade on margin they won't be forced to sell and as long as they hold their own keys they are unaffected if exchanges are crashing.
From a "price" perspective the current events might be bad for the crypto ecosystem, but from a "health" perspective I think that they could be positive, as only the responsible players with healthy business practices are going to survive.
The concern is propagation. If margin calls blow up individual organizations or institutions, that's bad but not a fundamental threat. The issue is that things are connected.
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> Is auto-liquidation a bad thing?
Not if you pretend everyone is an island and economies aren't interconnected.
Say you have 100 USD, but want to make a bigger bet on crypto than that. You borrow another 900 USD from a crypto lender and invest the 1000 USD in some cryptocurrency. If the currency you invested in goes down by 10%, your original position of 1000 USD will be worth 900 USD, and you will still owe the lender 900 USD so your original 100 USD stake has been lost completely. The lender will then protect their loan by forcing you to sell the 900 USD in crypto that you still have and repaying the loan. This is in itself not unique to crypto (google the term "margin call" if you want to know more), but crypto is usually more automated about it and exchanges will sell positions without manual intervention. This sell pressure can push the coin even lower, leading to a chain reaction of liquidated positions.
Often, the lender is also the exchange through which people hold their crypto so they don't even have to contact the holder before they sell their holdings.
Two things to add:
1. The price of an asset need not be a nice continuous line. It can jump.
2. That's why liquidation occurs not at -10%, but at some point before that, to manage this gap risk. Might be at -7%, or whatever. This reduces, but does not eliminate gap risk. For that, the crypto exchanges have insurance funds.
Here's a concrete example. AAVE is a protocol that allows lenders to lend money to borrowers in a decentralized manner.
So as a borrower, today, if you were to borrower 8000 USDC and deposit 10 ETH as collateral, the AAVE protocol would automatically sell your collateral if the ETH price went to 941$. So your position is "auto liquidated". https://aavecalculator.com/
AAVE currently has ~$9.9B in assets locked into its protocol.
That no different from any margin loan
It is no different at all. However, in traditional finance that is called a "margin loan" in defi it is called a "crypto interest account paying 20% with 0 chance of losing all your money"
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Somewhat, look at toomuchtodo's comment. In tradfi, there are humans involved and you might be able to avert liquidation.
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Yes it is. In traditional finance, especially at the big players, the bank will call the person about to be margin called to tell them they need to post more collateral, or if it looks like the market is being manipulated they’ll let the loan be undercollateralized for a short time. Defi auto liquidation makes it much easier to spiral due to unwinding after small losses.
Not sure if that's what parent is about, but the reference may be to on-chain lending solutions that use price oracles to determine liquidation prices based on amount of collateral deployed.
There are 9-digit lending positions in $ of crypto collateral that will be forcefully sold into the market if BTC/ETH keep dropping. Unless more collateral will be deployed, which lowers the forced liquidation price.
DeFi - Contracts are code.
TradFi - Your word is your bond.
This ! The "idea" of Defi was that w wouldn't need "regulations and rules" since we could 'just' look at the actual deployed code(eth contract for example) to see if you going to get screwed.
Of course few ppl actually look at the code, or sometimes the code is just bad and you get bad actors willing to exploit this.
That being said: In practice and real life there are a bunch of dodgy companies and badly written eth-contracts(code).
I suspect most experienced software engineers would find that all rather obvious. Bugs are a fact of life. Even formal verification can't save you from this. Good software is built to be resilient to our own bugs, because they are simply inevitable. It's not about good or bad programming, every one has the ability to make a simple mistake resulting in huge consequences. It's basically a rite of passage to have crashed a service with a code push.
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