How to Do DeFi on Polkadot: What Liquidations Are and How to Avoid Them
In general, to be liquidated means to have some or all of your debt sold off or transferred to a third party liquidator at a discount to the third party liquidator, and a penalty to the borrower. Liquidations function differently on different types of platforms, but in general, the purpose of a liquidation is to transfer debt that is at risk of becoming insolvent away from the platform. This is to protect the platform itself from becoming insolvent.
Parallel’s liquidations work by transferring a portion of the user’s collateral assets to a liquidator at a 10% discount (configurable via governance). The discount is essentially a penalty paid by the borrower to keep their loan in good health, by moving their at-risk debt off of the platform.
On Parallel, which is primarily a lending platform, a user’s debt becomes eligible for liquidations when the value of their loan is greater than or equal to 50% of their collateral. On Parallel, each borrower is eligible to borrow a maximum of 50% of their total deposit. The user can track their usage through the app under the term ‘Borrower Limit Left,’ as below. The borrower’s position is at risk of being liquidated when this figure is greater than or equal to 100% of their Borrower Limit Left, which is also equal to 50% of their collateral.
Three Liquidation Factors
In the end, all that matters is whether user’s debt to collateral ratio is greater than or equal to 50% of their collateral (configurable by governance). If this is the case, then the user’s debt can become liquidated. Combinations of the three following factors can lead to the user’s debt being liquidated, or a liquidation can occur as the result of only one of the following three factors below. The first two have to do with the relative price of the asset loaned and borrowed, and the third has to do with the interest rate.
1. Collateral Price
The first occurs as the result of the assets collateralized by the user moving down in price, while the price of their borrowed asset/s moves up or stays the same. Say, for instance, the user adds DOT collateral and borrows KSM. If the price of DOT goes down while KSM stays the same and the user’s KSM becomes worth more than 50% of their collateral position paid in DOT, the user’s debt can be liquidated. To help avoid this kind of liquidation, you can use stable coins as collateral, and always be mindful that 50% of your collateral (often called collateral ratio, or CR for short) does not become less than of the value of your loan.
2. Loan Price
The second kind of liquidation occurs when the assets borrowed by the user move up in price, while the asset collateralized moves down, or stays the same. Using the same example as above, if the user’s KSM suddenly goes up in price, and the value of their borrowed KSM surpasses the value of 50% of their collateralized DOT, the user’s debt becomes eligible for liquidations. To help avoid this kind of liquidation, you can take out loans in stable coins and always be mindful that your loan does not become more valuable than 50% of your collateral.
3. Interest Rate
As you might notice, the above two kinds of liquidations occur when the user borrows a different token than they supply. If the user borrows the same token they supply, their risk of liquidation decreases dramatically, because the price of like-kind assets are usually very close. That said, it is still possible to be liquidated while borrowing like-kind pairs. The third and final way a user’s position can be liquidated is if the cost of their interest rate causes the value of their loan + interest to be greater than 50% of their collateral. Imagine a user wants to stake their assets on margin via Parallel, because they’d like to “lever up” to increase their lending yield. The longer they lever up, the greater the accumulation of their interest rate. If they do this for too long, with too much leverage, the cost of their loan + interest can become greater than 50% of their collateral. At that point, their loan becomes eligible for liquidations. To avoid this kind of liquidation, always be sure that your interest rate levels don’t cause your loan to exceed your Borrower Limit Left.
A special thanks to our partners for their continued support.
This article contains forecasts, projections, goals, plans, and other forward-looking statements regarding Parallel’s financial results and other data. Such forward-looking statements are based on Parallel’s assumptions, estimates, outlook, and other judgments made in light of information available at the time of preparation of such statements and involve both known and unknown risks and uncertainties. Accordingly, plans, goals, and other statements may not be realized as described, and actual financial results, success/failure or progress of development, and other projections may differ materially from those presented herein. Even when subsequent changes in conditions or other circumstances make it preferable to update or revise forecasts, plans, or other forward-looking statements, Parallel disclaims any obligation to update or revise this article. Information concerning risk or returns (including features under development) contained herein is not intended as advertising or as financial advice.