Mitigating Decentralized Finance Liquidations with Reversible Call Options

TL;DR

This paper introduces reversible call options and a protocol called Miqado to mitigate liquidations in DeFi, significantly reducing liquidation collateral and preventing systemic failures.

Contribution

It presents a novel financial primitive, reversible call options, and a new protocol, Miqado, that actively reduces liquidations in DeFi lending systems.

Findings

Miqado reduces liquidated collateral by 89.82% in simulations.

Reversible call options allow termination before maturity, enabling new liquidation mitigation strategies.

Miqado incentivizes supporters to top-up loans, delaying or preventing liquidations.

Abstract

Liquidations in Decentralized Finance (DeFi) are both a blessing and a curse -- whereas liquidations prevent lenders from capital loss, they simultaneously lead to liquidation spirals and system-wide failures. Since most lending and borrowing protocols assume liquidations are indispensable, there is an increased interest in alternative constructions that prevent immediate systemic-failure under uncertain circumstances. In this work, we introduce reversible call options, a novel financial primitive that enables the seller of a call option to terminate it before maturity. We apply reversible call options to lending in DeFi and devise Miqado, a protocol for lending platforms to replace the liquidation mechanisms. To the best of our knowledge, Miqado is the first protocol that actively mitigates liquidations to reduce the risk of liquidation spirals. Instead of selling collateral, Miqado incentivizes external entities, so-called supporters, to top-up a borrowing position and grant the borrower additional time to rescue the debt. Our simulation shows that Miqado reduces the amount of liquidated collateral by 89.82% in a worst-case scenario.