Breaking Down the Design Space of Money Market Liquidations

APR 13, 2022 • 17 Min Read

DISCLOSURE: DELPHI VENTURES HAS INVESTED IN LUNA AND ANC. MEMBERS OF OUR TEAM ALSO OWN AAVE AND COMP. THIS STATEMENT IS INTENDED TO DISCLOSE ANY CONFLICT OF INTEREST AND SHOULD NOT BE MISCONSTRUED AS A RECOMMENDATION TO PURCHASE ANY TOKEN. THIS CONTENT IS FOR INFORMATIONAL PURPOSES ONLY AND YOU SHOULD NOT MAKE DECISIONS BASED SOLELY ON IT. THIS IS NOT INVESTMENT ADVICE.

Key Takeaways

  • To find the merits and demerits of various liquidation mechanisms employed by DeFi money markets, we evaluate them on the following criteria: democratization of liquidation profits, speed of liquidations, transaction costs, protocol capital efficiency, price impact of liquidations, and penalties levied on borrowers.

  • The fixed liquidation discount model is the simplest, and most effective, but can make bad situations worse (during sharp drawdowns) as liquidators engage in Priority Gas Auctions when the base L1 is already congested. Often times, under this model, a larger than necessary portion of a borrower’s loan is liquidated as the bigger a liquidation is, the more profit a liquidator earns.

  • Stability pool based liquidations democratize the process to a broader community instead of being dominated by bots. Users can deposit funds into this pool to take part in liquidations. On the downside, passive liquidations rely on individual users selling the collateral they bid on, which could reduce or eliminate profits during extended drawdowns. However, new products such as B. Protocol automate this component, vastly improving the UX of passive liquidations.

  • Dutch auctions are proving to be a fairly effective method for liquidation. However, these methods induce larger discounts the longer an auction runs, providing liquidators with a disincentive to be early. Euler’s “quasi-Dutch auction,” on the other hand, has sped up the process of a general Dutch auction, thereby improving efficiency.

  • Liquidation queues facilitated by the likes of Kujira on Terra are akin to stability pools, providing users with an easy UI and the ability to bid on liquidations in an orderbook-like fashion. This is primarily used to process liquidations on Terra’s Anchor money market.

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