In the rapidly evolving landscape of decentralized finance (DeFi), liquidations play a pivotal role in maintaining the stability and integrity of lending and borrowing protocols. As financial transactions and assets move at unprecedented speeds, the mechanisms for managing undercollateralized loans must be robust and efficient. This report delves into the critical systems that underpin DeFi liquidations, exploring their functionality, types, and the innovative technologies that support them. By examining both instant and auction liquidations, as well as the integral role of blockchain oracles, we gain a comprehensive understanding of how DeFi protocols mitigate risk, safeguard assets, and ensure the ongoing health of their ecosystems.

Liquidations

Above all, many of DeFi’s critical lending and borrowing protocols are anchored by the support of liquidation systems. As noted in previous sections, liquidations occur when the value of a loan’s collateral falls below the value of the borrower’s outstanding debt, including interest. This means that the position is now under-collateralized and poses a threat to the health of the lending protocol. To prevent the accumulation of these bad undercollateralized positions, many DeFi protocols enable third-party anonymous liquidators to repay the debt, allowing the liquidators to take possession of the remaining collateral.

Protocols often choose to utilize third-party liquidations due to the gas cost of executing liquidation transactions. Automating this process would require a significant increase in the operating costs of the protocol, which would directly impact profitability. Not to mention, designing liquidation systems is extremely complex as it would require the protocol to devise an algorithmic way to strategically determine whether a position should be liquidated and when to formally execute the liquidation.

The timing is fundamentally crucial because if a position’s debt value surpasses that of the collateral, liquidation becomes unprofitable for the liquidators, leaving the protocol with bad debt. This is precisely what happened to Aave during the CRV exploit.

Types of Liquidations - Instant Liquidations

Liquidations are a common element in traditional finance as well, but they work quite differently in DeFi. Because of the rapid volatility of many cryptocurrencies, liquidations within DeFi are frequent, instantaneous, and executed by often anonymous operators. This is otherwise known as the concept of instant liquidations.

Unlike the traditional financial sector, where liquidation processes may involve lengthy procedures and regulatory oversight, DeFi platforms automate and expedite these operations. Here, anonymous liquidators play a pivotal role, operating without the need for conventional vetting processes. This setup underscores a fascinating balance: incentivizing liquidators to swiftly protect lenders from potential bad debt while safeguarding the ecosystem's integrity.

Instant Liquidations occur when the DeFi protocols automatically execute liquidation procedures in real time as soon as a loan becomes undercollateralized. This is possible due to the integration of smart contracts, which enforce the terms of loans autonomously. The principle of solvency underpins the necessity for Instant Liquidations.

For a loan to remain solvent, its collateral value must consistently outstrip the debt it secures. However, in DeFi's volatile markets, a solvent loan can quickly become insolvent. Instant Liquidations mitigate this risk by allowing for the immediate sale of collateral once it falls below a predefined loan-to-value (LTV) threshold, ensuring lenders are protected against significant losses.

While Instant Liquidations serve as a crucial risk management tool, they also introduce challenges. The primary concern is ensuring that these processes are fair and do not unduly penalize borrowers due to temporary market dips. Moreover, the reliance on anonymous liquidators raises questions about the execution of liquidations and the potential for manipulation.

To address these issues, DeFi protocols implement over-collateralization and carefully calibrated collateralization ratios. These measures provide a cushion against market volatility, ensuring that liquidators are incentivized to act promptly while offering borrowers protection against immediate liquidation for minor infractions.

The collateralization ratio is instrumental in determining when a loan is eligible for Instant Liquidation. By setting this ratio to reflect the volatility of the collateral asset, DeFi platforms can create a buffer that allows for market fluctuations without triggering unnecessary liquidations. This approach ensures that liquidators are motivated by the prospect of profit, making the system resilient to market shifts while protecting the interests of all parties involved.

Types of Liquidations - Auction Liquidations

Following the discussion on instant liquidations in DeFi, it's important to delve into another critical mechanism employed by DeFi platforms to manage loan defaults: auction liquidations. Unlike the straightforward process of instant liquidations, auction liquidations introduce a competitive bidding system, aiming to achieve more efficient and fair outcomes, particularly for larger loans that present a higher risk profile.

Instant liquidations, while efficient, can disproportionately benefit liquidators, especially in the context of larger loans. The profit from these transactions often scales with the size of the loan, creating a scenario where larger loans are more lucrative for liquidators but inherently riskier for borrowers. This dynamic can disadvantage borrowers with substantial loans, prompting the exploration of alternative liquidation mechanisms like auctions.

Auction liquidations are designed to mitigate the risks associated with instant liquidations by fostering competition among liquidators. The goal is to award the liquidation contract to the bidder willing to accept the smallest profit margin, ensuring a more equitable distribution of risk and reward. This competition can lead to more favorable outcomes for borrowers, potentially reducing the cost of liquidation.

Types of Liquidations - MakerDAO Liquidations

Liquidations are critical to the health of the MakerDAO ecosystem. They help to ensure that DAI is always backed by enough collateral (in USD terms) by closing out Vaults that are under their minimum required Collateralization Ratio. Liquidations are triggered automatically by the protocol in which the protocol sells/auctions enough of the collateral off to service the debt plus a Liquidation Penalty. The Protocol's health is determined after comparing the Liquidation Ratio to the current collateral-to-debt ratio of a Vault. Each Vault type has its own Liquidation Ratio, and MKR voters determine each ratio based on the risk profile of the particular collateral asset type.

In May of 2021, Maker introduced Liquidations 2.0 after deficiencies in its prior liquidation method became apparent. The liquidation is actually an auction that anyone can participate in, and bidders in these auctions are known as Auction Keepers. They are external actors that are incentivized by profit to automate certain operations around the Ethereum blockchain. Proceeds from Liquidation Penalties are put towards the Surplus Auctions, which result in burned MKR.

Since then, liquidations have not been handled via a single Dutch auction. In a Dutch auction, the collateral is initially priced at a high bid that gradually decreases until a buyer buys at that price. If no buyer is present, the collateral continues to be discounted up to a predefined limit or until the auction ends.

In this scenario, potential liquidators must constantly decide whether to purchase at the present price or wait until the discount increases. If the second option is selected, the potential liquidator risks losing the asset to a competitor who is willing to purchase at a slightly higher rate. Thus, liquidators will choose to liquidate when the bid is profitable enough for them to accept.

Dutch auctions enable larger loans to be profitably liquidated at a reduced discount percentage compared to smaller loans. Consequently, the discount can scale more effectively with gas prices over that period. During periods of network congestion, a greater percentage discount will be required to conclude the auction than during periods of network slack, all else being equal.

liquidations table — Source: Delphi Digital

Oracles

DeFi lending and derivatives protocols have utilized a technology called oracles for many important functions. A blockchain oracle serves as a crucial link between on-chain systems, such as smart contracts, and off-chain data providers. By sourcing, verifying, and transmitting off-chain data to the blockchain, an oracle expands the capabilities of smart contracts, which otherwise would have limited access to on-chain data alone. Oracles enable smart contracts to leverage trusted external data to execute their functions.

For example, oracles decide when a loan should be liquidated based on the current value of collateral. This generally restricts eligible collateral to assets that have reliable oracle price feeds. Similarly, derivatives protocols that rely on oracles lack internal price discovery mechanisms and are susceptible to lags in price updates, which can limit their scalability and user experience.

It's important to note that a blockchain oracle is not the direct source of data but rather the system responsible for querying, confirming, and authenticating off-chain data sources. It then relays this information to the blockchain network. The transmitted data can include asset prices, natural disaster updates, statistics, political events, geolocation data, and more.

Typically, a blockchain oracle consists of a smart contract operating on the blockchain and an off-chain component known as the oracle. The smart contract receives data requests from other on-chain applications and relays them to the oracle. The oracle node queries data sources through APIs, retrieves the relevant information, and stores it on the blockchain.

Blockchain oracles play a critical role in enabling the execution of agreements through smart contracts. While smart contracts are self-governing programs operating on the blockchain, their ability to interact with deterministic off-chain systems poses complexity. Deterministic systems produce expected results based on specific inputs and static states. Blockchains aim for consensus on basic binary questions relying on data already stored in their ledgers. However, incorporating off-chain data directly into blockchains would disrupt determinism, as off-chain data is subject to frequent changes. This would hinder consensus among nodes and undermine the distributed nature of blockchain.

Oracles solve this problem by pulling external data and relaying it to blockchains for use in smart contracts. By doing so, they allow blockchains to securely utilize off-chain data without compromising consensus.

Nonetheless, the use of oracles introduces challenges, including the potential for incorrect or manipulated data inputs. Centralized oracles can act as single points of failure and raise trust concerns. To address these issues, multiple oracles can be used to provide redundant data, and decentralized oracles offer tamper-proof and transparent data sourcing through distributed networks of nodes.

Categorizing Oracles

There are two broad categories of oracles: centralized and decentralized. Centralized oracles serve as single sources of truth, controlled by a single entity, and provide data to smart contracts. They offer faster data retrieval and greater control but face drawbacks such as single points of failure and lack of transparency. Decentralized oracles, on the other hand, leverage networks of nodes to securely access and validate external data. They offer advantages like no single point of failure, transparency, and censorship resistance. However, they can be more complex to set up and may have scalability limitations.

Chainlink Oracle Network

Chainlink is a chain-agnostic and API-agnostic decentralized oracle network initially built on Ethereum. Chainlink’s designed to connect off-chain data sources, such as financial market data to on-chain smart contracts. “Oracles'' can be thought of as the bridge on which on-chain smart contracts access, retrieve, and verify data coming from outside of a blockchain. They also relay data and instructions from smart contracts to other off-chain systems.

For example, the Ethereum network is only aware of the transactions, blocks, and ether that live within its closed Ethereum Virtual Machine (EVM). It has no way of ‘knowing’ the current price of oil, who won the Yankees game, or if the stock market dropped 5w this week. However, for Ethereum (or any blockchain) to disrupt traditional finance and provide greater value to its users, it will need a way to incorporate these kinds of data in a trustless, decentralized way. The ideal oracle should provide perfect accuracy, be manipulation-resistant, and be sufficiently decentralized from a security standpoint.

The challenge of getting off-chain information on-chain in a reliable, trust-minimized manner is generally known as the "oracle problem" and has remained largely unsolved since the creation of Bitcoin. Using information sourced outside the native blockchain introduces new potential attack vectors--i.e., how accurate is this data? If the data provided to the smart contract could ultimately be used to exploit the system for millions of dollars, then an attacker has the incentive of up to millions of dollars to manipulate that data. Because of this, the oracle network must be designed to reduce the impact of bad actors, reduce their incentive to provide inaccurate data, and minimize trust around one data point.

Many early attempts to solve this issue resulted in semi-trusted multi-signature schemes that just moved the points of trust (e.g., potential points of failure or manipulation) to different locations. Aside from being accurate, the oracle network must be resilient and robust enough to not become a single point of failure. The collection of oracles must be decentralized enough in numbers, geography, data sources, hardware/software, etc. (just like Bitcoin ASICs) to make them resistant to corruption, manipulation, and downtime. Decentralization among blockchains and oracle networks remains a spectrum with different use cases requiring different levels of security and decentralization. All attempts to create a fully decentralized system come with trade-offs to speed, costs, convenience, and performance.

Oracles can, in theory, connect blockchains and their token incentive structures to nearly anything. Creating verifiable, trusted smart contracts tied to real-world identities could penetrate the voting, passport, and medical history industries. Creating access to reliable and accurate real-world data also opens the door for decentralized sports betting, prediction markets, and insurance, representing trillions in combined economic activity.

Chainlink puts forth its solution to the oracle problem by connecting different blockchains to the off-chain world while providing “reliable tamper-proof inputs and outputs for complex smart contracts on any blockchain.” In addition, Chainlink aims to become the standard for interacting with other off-chain services, such as payment gateways for use cases, including financial data, financial agreements, insurance, and more.

As an oracle, the solution it offers is trustless connectivity to any API endpoint, including off-chain data sources such as web APIs, data and price feeds, bank or retail payment systems, events data, sports data, market data, IoT, or biometric sensors to a blockchain by retrieving and verifying data originating outside the network. These off-chain data sources are important for various financial services, such as collateral-backed loans and the settlement of derivatives prices.

Chainlink’s primary use case is bringing trust-minimized and secure third-party data via its secure middleware solution without interfering with the blockchain’s consensus. Therefore, Chainlink is a highly secure and flexible oracle network interfacing with the legacy world and its real-world data. Chainlink also offers a blockchain abstraction layer for enterprise use, which allows enterprises that want to become blockchain-enabled to integrate with Chainlink for access to many blockchain networks with only one integration.

Oracle-Free Protocols: Peer-to-Peer Lending and AMM-based Hybrids

While the majority of DeFi utilizes oracles, some protocols have chosen to build oracle-free, moving away from the dependence on oracles. While oracle exploitation and vulnerabilities go away, this strategy is not without its own trade-offs.

Overall, oracle-free designs can be divided into two categories: peer-to-peer (P2P) lending and hybrid protocols built on automated market makers (AMMs).

P2P Lending shifts the burden of pricing from the protocol to the user. It works by allowing lenders to decide their own value comparisons, leading to the creation of an order book similar to centralized exchanges.

So, this means that loans can be created from any on-chain collateral, removing the burden of bad debt from the protocol and allowing it to function autonomously from the health of the loans being agreed upon. However, this model does re-introduce an indirect connection to oracle risk as users or external protocols would likely still rely on oracles to rebalance positions. Some examples of protocols in this category include Blur’s Blend, PWN.xyz, and Ajna.

In contrast, AMM-based hybrid protocols are built on top of AMM liquidity provider (LP) positions (like Uniswap V3) and use DEX liquidity to provide users with leverage or derivative instruments to use. In this model, LP positions function as the oracle. Examples of protocols in this category include InfinityPools, Limitless, and Panoptic.

Conclusion

The intricacies of liquidation mechanisms in DeFi highlight the sophistication and innovation inherent in this burgeoning financial sector. Instant liquidations, driven by smart contracts, offer rapid responses to market volatility, while auction liquidations introduce competitive elements to balance risk and reward. The essential function of oracles is to bridge the gap between on-chain operations and off-chain data, ensuring the accurate and timely execution of smart contracts. As DeFi continues to evolve, these systems will undoubtedly adapt and improve, further enhancing the stability and efficiency of decentralized financial markets. The ongoing refinement of these mechanisms underscores the dynamic nature of DeFi and its potential to revolutionize traditional finance.

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