How Loan Liquidations Work

A detailed explanation of how liquidations work in crypto lending and how you can avoid being liquidated.

Liquidation is a common concept in the crypto world. It is a scary one, no doubt, but it happens sometimes, seemingly without provocation. For example, on May 9, 2022, more than $1 billion worth of assets were liquidated when the crypto world suffered a meltdown. That is quite a lot!

These liquidation events cut across many aspects of the crypto world, including crypto loans. However, the liquidation process of crypto loans is quite different from that of other sectors of the crypto world.

That is what this article will focus on. We will discuss how liquidations work in crypto lending and how you can avoid being liquidated. First, though, let us discuss how liquidations work in traditional finance.

Liquidation in Traditional Finance

In traditional finance, liquidation refers to the process of repaying or liquidating a loan. If the borrower does not have enough funds to repay the loan, liquidators may step in and sell off the assets put down as collateral to repay the creditors.

A typical example of a traditional loan liquidation is an SBA loan liquidation.

SBA Loan Liquidations

An SBA (Small Business Administration) loan is a loan taken by a small business with a good credit score for the purpose of expanding the business. The main difference between this loan and other business loans is that the government partially backs SBA loans.

SBA loans come with an SBA guarantee (a guarantee that the government will pay lenders back if the borrowers default). Therefore, if, even after selling off company assets, a borrower still cannot repay an SBA-backed loan, the lender (usually a bank) will request the transfer of the loan to liquidation status.

After due processing, the government will repay the loan and cover all costs incurred in pursuing the liquidations, including legal fees.

What is Liquidation in Crypto Loan platforms?

A crypto loan liquidation is when your collateral assets are sold to repay your debt. It follows the same principle as loan liquidations in traditional finance. The major difference is that the collateral assets are cryptocurrencies and are more volatile.

This type of liquidation usually happens in cases of high volatility in the crypto markets, when the value of your collateral assets has dropped significantly and has approached the liquidation threshold.

Before a liquidation happens, your lending platform will send you a margin call. You can then decide if you will add more collateral assets to avoid liquidation or give up on your collateral altogether and bear your loss.

However, unlike other aspects of the crypto world where you lose everything in the event of a liquidation, you only lose your collateral in crypto loan liquidations.

The borrowed assets are still yours, and you can use them however you like. You might even be able to buy back your collateral assets at a discounted price later.

Why Do Crypto Lending Platforms Liquidate Loans?

Crypto lending platforms serve as mediators in a crypto loan arrangement. In some cases, they are the lenders. In other cases, they invite lenders to deposit funds with them, which they then lend to borrowers.

Whichever the case, lenders must earn interest. If they do not earn interest, there is little incentive to lend their assets. They earn such interest when borrowers repay the loans with interest.

If all goes well and the crypto market is relatively stable during the loan period, the borrower will repay the debt with interest and get back their collateral. In such cases, liquidation is not necessary.

However, when crypto prices go down and the value of the collateral asset decreases, borrowers may be less motivated to pay back their loans if their loan value is now greater than the collateral value. Since there are little or no credit checks with crypto loans, borrowers may simply vanish with the borrowed assets, leaving the lenders at a loss.

Liquidation ensures that this does not happen. The lending platform sells the collateral before its price goes further down. That way, lenders always earn interest, regardless of the market conditions.

Note that crypto lending platforms do not take pleasure in liquidating loans; they only do it when necessary. Thus, liquidation is essentially a stop-loss mechanism for lenders and is crucial for the crypto lending ecosystem.

Some Crypto Liquidation Concepts

Before we discuss how the liquidation process works, let's explain some concepts that are associated with crypto loan liquidations.

Loan-to-Value Ratio

Loan-to-Value (LTV) ratio is a ratio of your collateral asset value to your loan value. It is expressed as a percentage and is your loan amount divided by your collateral value times 100%. For example, an LTV of 50% means that your loan amount is half of your collateral asset value.

When the price of your collateral goes down, your LTV increases, and vice versa. The higher your LTV, the more danger your collateral asset is in.

Overcollateralization

Over-collateralization is when the value of your collateral is more than that of your borrowed assets. It is a necessity in the crypto lending world because of the high volatility of crypto assets.

This arrangement protects the lender as it ensures that lenders won't be at a loss no matter the market conditions.

Margin Call

When the value of your collateral is getting dangerously close to the liquidation threshold, your lending provider might issue a warning to you via SMS or email. This is a margin call.

To avoid liquidation, you need to act fast after getting a margin call. You can either add more crypto assets to your collateral or close off your loan and salvage your remaining assets.

How does the liquidation process work?

We will use a case example involving Dean, a savvy investor, to better understand this process.

So Dean borrows a $10,000 USDT loan at BlockFi with an LTV ratio of 50% and BTC as his collateral asset. To secure his loan transaction, he needs to put down $20,000 worth of BTC.

If BTC's price remains reasonably constant throughout its loan period, there would be no need for liquidation. He would simply repay his $10,000 USDT loan with interest and get back his BTC collateral.

However, if BTC's price declines during that period, his LTV will increase accordingly. If his LTV gets to 70% (BlockFi's minimum margin call threshold), he will get a margin call on his account. At that point, he needs to add to his collateral to reduce his LTV ratio and, subsequently, his liquidation risk.

If he does not add more collateral after getting a margin call and his LTV ratio increases to 80% (BlockFi's liquidation threshold), the platform will liquidate his collateral. Depending on market conditions, the liquidation may be partial or complete.

This is just an example using BlockFi's crypto lending parameters. Other crypto lending platforms use a combination of smart contracts and price oracles to determine liquidation prices. An example is Nexo, which recently teamed up with Chainlink (a smart contract oracle) to this effect.

What if My Collateral Increases in Value?

When this happens, you can apply for a reverse margin call. This is a financial tool that allows borrowers to take back some of their collateral if it has increased significantly in value.

Before your loan can be approved for a reverse margin call, it should meet the following conditions:

  • Your collateral value should have at least doubled. This means that your LTV ratio will be at least half of what it was when you applied for the loan.

  • You can only ask for a reverse margin call on your loan once a month.

Even if your crypto loan provider does not offer reverse margin calls, it is always good news if your collateral increases in value. At the very least, it makes it easier to repay your debt and means that you're farther away from liquidation.

Also, if you're thinking of locking in your gains before your loan period expires, you can close your loan, cash out on your profits, and reapply for your loan when you feel the market is favorable for it.

How to Avoid Being Liquidated on Your Crypto Loans

Consider Lending and Borrowing Stablecoins

Stablecoins are the 'cool guys' in the volatile crypto world. Apart from occasional smart contract failures like the recent UST failure, you can count on stablecoins to maintain their stability in times of extreme market swings.

Therefore, lending and borrowing stablecoins is one surefire way to reduce your exposure to liquidation events. If you are a lender, you can even earn higher interest when you lend stablecoins.

If you must dabble in other assets apart from stablecoins, choose well-established cryptocurrencies with large market caps. Coins like that do not usually undergo extreme price spikes.

Be Ready for Margin Calls

Ideally, a crypto lending platform should not liquidate loans without issuing a margin call to allow you to adjust your positions as necessary. Therefore, be alert and watch out for messages from your lending provider.

You should also take note of your liquidation price so that even if your lending provider does not alert you on time, you can know when you're getting dangerously close.

In addition, you should have extra liquidity already deposited into your lending platform. Sometimes, the market moves very quickly and leaves little chance for refinancing. In such cases, having funds on the ground saves you valuable time.

Conclusion

Liquidation is no fun, especially for the borrower. It's a last-resort, fail-safe mechanism that sits pretty at the heart of the crypto loan industry.

If you are a lender, liquidation ensures that you will get your interest no matter what. If you are a borrower, you should be watchful and act fast in times of market declines to avoid liquidation.