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). So, if a borrower still can't pay back an SBA-backed loan after selling off company assets, the lender (usually a bank) will ask for the loan to be moved to liquidation status.
After the proper steps have been taken, the government will pay back the loan and cover all costs, including legal fees, that have come up because of the liquidations.
What is Liquidation in Crypto Loan platforms?
When your collateral is sold to pay off your debt, this is called a "crypto loan liquidation." It follows the same principle as loan liquidations in traditional finance. The major difference is that the collateral assets are cryptocurrencies, which 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.
Whatever 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 their collateral back. 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 few or no credit checks for crypto loans, the person who borrows the money could just disappear with it, leaving the lender out of pocket.
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 market conditions.
Note that crypto lending platforms do not take pleasure in liquidating loans; they only do it when necessary. So, liquidation is a way for lenders to stop losing money and is a key part of 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 (LTV) ratio is a ratio of the value of your collateral assets to your loan value. It is given as a percentage and is equal to your loan amount divided by the value of your collateral 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.
Over-collateralization is when the value of your collateral is greater than that of your borrowed assets. Because crypto assets are so volatile, it is a must in the crypto lending world.
This arrangement protects the lender, as it ensures that lenders won't be at a loss no matter the market conditions.
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 cancel the loan and keep the ones you already have.
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 Nexo 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 the price of BTC stays fairly stable over the course of the loan, there would be no need to liquidate. 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% (Ledn's minimum margin call threshold), he will get a margin call on his account. At that point, he needs to add more collateral to lower his LTV ratio and, as a result, his risk of being forced to pay back the loan.
If he does not add more collateral after getting a margin call and his LTV ratio increases to 80% (Ledn'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 Ledn's crypto lending parameters. Other crypto lending platforms use a mix of smart contracts and price oracles to figure out what the prices will be when the loans are paid off. 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. You can count on stablecoins to stay stable even when the market is moving wildly, except when smart contracts fail, like the recent UST failure.
So, lending and borrowing stablecoins is one sure way to lower your risk of losing money in a liquidation event. If you are a lender, you can even earn higher interest when you lend stablecoins.
If you want to invest in something other than stablecoins, choose a cryptocurrency that has been around for a long time and has a big market cap. Coins like that do not usually undergo extreme price spikes.
Be Ready for Margin Calls
In an ideal world, a crypto lending platform shouldn't liquidate loans without giving you a margin call so you can make any necessary changes to your positions. 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.
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.