class: title-slide # Liquidations: DeFi on a Knife-edge <h2 class="sm-top-margin"> Daniel Perez <span class="very minor">Imperial College London</span><br> Sam M. Werner <span class="very minor">Imperial College London</span><br> Jiahua Xu <span class="very minor">University College London</span><br> Benjamin Livshits <span class="very minor">Imperial College London</span><br> </h2> <h3 class="sm-top-margin">March 4th, Financial Cryptography and Data Security 2021</h3> <br> <h4>Slides available at: http://bit.ly/defi-liquidations</h4> --- # Overview 1. Background 2. Model and methodology 3. Analysis and results 4. Takeaways --- class: middle, title-slide # Background --- # Smart contracts .pull-left-50[ * Programs deployed on a blockchain * Usually written in a high-level language and compiled into bytecode * Interacted with using transactions * Uses some metering mechanism ] .pull-right-50[  .caption[ Ethereum Smart Contracts overview] ] --- # On-chain building blocks .pull-left-50[ ## Oracles * Facilitate on-chain access to external information * Implemented as smart contracts being regularly updated * Often require some level of trust ] .pull-right-50[ ## Stablecoins * Assets of which the price is pegged to a currency (e.g. USD) * Can be implemented in very different ways (e.g. custodial vs non-custodial) * Movements above/below target are not uncommon ] --- # Protocols for Loanable Funds (PLF) * Protocol that intermediates funds between users * Unlike peer-to-peer lending, funds are pooled * Requires users to deposit collateral .text-center[  .caption[Protocols for Loanable Funds overview] ] --- # PLF building blocks * Interest rate models: some function(s) taking liquidity as an argument and returning an interest rate * Collateralization: deposit that can be sold off to recover the debt of a defaulted position * Liquidations: the process of selling a borrower’s collateral to recover the debt value upon default * Governance mechanism: decentralized governance typically achieved through an ERC-20 governance token, where token holders' votes are in proportion to their stake --- # PLF use cases * Earning interest: Liquidity providers of funds are incentivized by accrued interest * Leveraged short position: Borrowing funds of an asset expected to depreciate in value * Leveraged long position: Increasing exposure to an asset expected to appreciate in value * Liquidity mining: PLFs may distribute governance tokens to their users to incentivize liquidity providers and/or borrowers --- class: middle, title-slide # Model and methodology --- # PLF definitions * *Market* A smart contract acting as the intermediary of loanable funds for a particular crypto-asset, where users supply and borrow funds. * *Supply* Funds deposited to a market that can be loaned out to other users and used as collateral against depositors’ own borrow positions. * *Borrow* Funds loaned out to users of a market. * *Collateral* Funds available to back a user’s aggregate borrow positions. * *Locked funds* Funds remaining in the PLF smart contracts, equal to the difference between supplied and borrowed funds. --- # Agents in the system * *Supplier* A user who deposits funds to a market. * *Borrower* A user who borrows funds from a market. Since a borrow position must be collateralized by deposited funds, a borrower must also be a supplier. * *Liquidator* A user who purchases a borrower’s supply in a market when the borrower’s collateral to borrow ratio falls below some threshold. --- # Conditions for liquidation * All markets have a *collateral factor*, the ratio between supply and collateral funds * When computing collateral and borrowed funds across markets, amounts are converted to a common currency, e.g. USD or ETH * A user is liquidable if the *sum of his borrows exceeds the sum of his collateral* across all markets --- # Leveraging on PLFs .pull-left-50[ ## Example steps for leveraging 1. Supply ETH on a PLF. 2. Leverage the deposited ETH to borrow DAI. 3. Sell the purchased DAI for ETH. 4. Repeat steps 1 to 3 as desired. ] .pull-right-50[  .caption[Steps of leveraging using a PLF] ] --- # Analyzing Compound We analyze the different events emitted by Compound smart contracts .center-block.max-content[ Event | Description | State change ----------|-----------------------|------------- Borrow | New borrow is created | Borrow Mint | cTokens minted for deposit | Supply RepayBorrow | Borrow is partially/fully repaid | Borrow LiquidateBorrow | Borrow is liquidated | Supply & Borrow Redeem | cTokens are used to redeem deposit of asset | Supply .caption[Main events on Compound] ] --- class: middle, title-slide # Analysis --- # Borrowers and suppliers Sharp increase when `COMP` rewards started to be distributed .pull-left-50[  .caption[Number of suppliers and borrowers] ] .pull-right-50[  .caption[Amount of funds supplied, borrowed and locked] ] --- # Distribution of funds .pull-left-50[ Top user accounts for 27.4%; top 10 users account for 49%  .caption[Distribution of supplied funds] ] .pull-right-50[ Top user accounts for 37.1%; top 10 users account for 59.9%  .caption[Distribution of borrowed funds] ] --- # Leveraging spirals * Leveraging spirals is an important reason for concentration in top borrowers/suppliers * Analysis of the top account * Provided in total 55M USD to the protocol * Used spirals to supply 342M USD and borrowed 247M * Analysis of all accounts * Over 2,100 accounts (40% of total number borrowers) use leveraging spirals * Over 600M USD (~50% of the total supply) is supplied using spirals --- # Liquidation risk .pull-left-50[ * `COMP` launch has changed users' behavior * Before launch, almost all users were at least 25% over their minimum collateral threshold * After launch, more than 40% of the users were within 5% ] .pull-right-50[  .caption[Collateral locked over time, showing how close the amounts are from being liquidated] ] --- # Price fluctuation and liquidation risk .pull-left-50[ * Users rely on DAI being stable * Small variations in DAI price can create large liquidations: 3% price change would have made more than 10M USD liquidable * This happened last November: over 88M USD liquidated ] .pull-right-50[  .caption[Sensitivity analysis of the liquidable collateral amount given DAI price movement] ] --- # Liquidations and liquidators Both liquidated amount and liquidation efficiency has increased with time .pull-left-50[  .caption[Liquidations over time] ] .pull-right-50[  .caption[Number of blocks elapsed from the time a position can be liquidated to actual liquidation] ] --- class: middle, title-slide # Takeaways --- # Takeaways * Governance token has changed PLF users' behavior significantly * A lot of liquidity was attracted but users are taking more and more risks * Users tend to underestimate the volatility of stable coins * Small price deviations can lead to large liquidations * Large amounts were liquidated last November * Liquidators are becoming more efficient * More than 70% of the liquidations happen in the block where positions became liquidable