Liquidations: DeFi on a Knife-edge

TL;DR

This paper provides an empirical analysis of liquidation dynamics in DeFi protocols, focusing on Compound, revealing how small price changes can trigger large liquidations and how liquidator efficiency has improved over time.

Contribution

It offers the first detailed empirical study of liquidations in DeFi loan protocols, analyzing participant behavior, protocol risk, and the impact of incentive structure changes.

Findings

A 3% asset price change can trigger over $10 million in liquidations.

Liquidator efficiency has increased, with over 70% of liquidable positions being immediately liquidated.

Misconceptions about stablecoin stability increase liquidation risks.

Abstract

The trustless nature of permissionless blockchains renders overcollateralization a key safety component relied upon by decentralized finance (DeFi) protocols. Nonetheless, factors such as price volatility may undermine this mechanism. In order to protect protocols from suffering losses, undercollateralized positions can be liquidated. In this paper, we present the first in-depth empirical analysis of liquidations on protocols for loanable funds (PLFs). We examine Compound, one of the most widely used PLFs, for a period starting from its conception to September 2020. We analyze participants' behavior and risk-appetite in particular, to elucidate recent developments in the dynamics of the protocol. Furthermore, we assess how this has changed with a modification in Compound's incentive structure and show that variations of only 3% in an asset's dollar price can result in over 10m USD becoming liquidable. To further understand the implications of this, we investigate the efficiency of liquidators. We find that liquidators' efficiency has improved significantly over time, with currently over 70% of liquidable positions being immediately liquidated. Lastly, we provide a discussion on how a false sense of security fostered by a misconception of the stability of non-custodial stablecoins, increases the overall liquidation risk faced by Compound participants.