DeFi Talks with DeFi Dad - Understanding the Importance of Liquidations in DeFi
Primer: DeFi Dad invited Yaron Velner and Eitan Katchka of B.Protocol for a second time to talk about the ever-increasing importance of liquidations in DeFi. They touched briefly on what B.Protocol is all about and how they are doing their best to educate users and platforms about the importance of risk management with reference to liquidations.
The Guests
Yaron Velner
Founder and Lead Developer - "The brain, muscles and vision" of B.Protocol
Before this, was the CTO of Kyber Network
Met Lui Loo, Kyber's CEO, while working on PhD in Computer Science
Started SmartPool as a semi-academic project in 2016 with Victor Tran, current Kyber's CTO. SmartPool was the first decentralized mining pool on Ethereum
This evolved to become Kyber in 2017 and Yaron took the CTO role till early 2020
Involved as a co-designer of the architecture and smart contracts of the WBTC protocol with BitGo team
Did development work on on-chain market-making tools created for DeFi before that term was even coined
After leaving Kyber in 2020, went into consulting with a few private companies to build liquidation bots for DeFi and CeFi
Realised that liquidations in DeFi are broken compared to CeFi
In Mar 2020, Black Thursday came and his worst fear came true
Liquidations on DeFi were not working when they were most needed
Yaron decided to develop B.Protocol and build a permissionless backstop liquidity protocol for DeFi lending platforms
Eitan Katchka
Head of Growth and Ecosystem Development
Went into crypto in 2014
Co-founder of La'Zooz - a decentralized car pooling dapp built on top of Bitcoin blockchain using MasterCoin (aka Omni Layer)
In 2017, led a project by Toyota Research Institute building mobility services on top of Ethereum and met Yaron
Joined B.Protocol before the project went live
What is B.Protocol?
Last spoke in Nov 2020 about a month after B.Protocol is launched
Started B.Protocol as a reaction to what happened on Black Thursday, where MakerDAO took on a lot of bad debts because liquidations that is supposed to happen did not occur
Moved on to v2 from there
v1 is for Compound and Maker
v2 is available on Ethereum main net for Liquity, Arbitrum for Vesta finance (a fork of Liquity) and Hundred Finance
B.Protocol is a liquidation engine for DeFi
Pools are committed liquidity provided by users to handle liquidations
Alternative L1s and L2s have lesser liquidity and with the current bearish market conditions, there is a liquidity contraction everywhere
This poses a higher risk of liquidations not happening as they should be
How do liquidations work?
Once the collateral factor of a position is reached, it means that the collateral you have does not have enough value to actually maintain the health of the loan that the account took against it
Liquidation is then triggered and someone will repay the loan in return for getting the collateral plus a bonus that the platform provides
Whenever there is a backstop on the platform, the repayment of the debt is made from the liquidity pool of the backstop instead of going through a DEX or AMM
B.Protocol have a mechanism to sell these collaterals to the base assets and redeposit back to the backstop pool
People who supply the liquidity in the backstop pool will get rewards as a user of B.Protocol, any liquidity mining rewards by the platform and the liquidation profits
Liquidation is very important to DeFi but it’s not the sexiest thing to people
Especially important in this market where there are many leveraged positions that are unwinding or liquidated
Important for lenders because otherwise might not reliably get their assets back in a permissionless trustless DeFi lending
The broken flash loan liquidation bot model
If a protocol forks Compound or just starting a new lending platform, one of the main tasks for a dev is to set up a flash loan liquidation bot running
These bots will scan the accounts in the platform periodically
Once liquidation is triggered on an account, it’ll take a flash loan to repay the debt
E.g. $1 mil worth of ETH is put up as collateral to borrow $500k USDC
As ETH drops and the account is liquidated, the bot will take up a flash loan to repay the debt of $500k USDC in return for $550k worth of ETH (assuming the penalty discount is 10%) from the collateral
The bot will have to sell the ETH collateral in a DEX to get USDC in order to repay the flash loan
In the recent weeks, liquidity on DEX are so strained that the slippage for the swaps is greater than the liquidation incentive
Anything slippage above 10% is bad and this will break the whole liquidation process
It will take a longer time to swap smaller amounts, hopefully, the price will not go down too much
Having a liquidation bot doesn’t mean liquidations will run smoothly
This is important because recently, a well-known DeFi hedge fund is rumoured to have been blown up
They had some debts and if these debts are not liquidated properly, it’ll cause a cascade of liquidations happening across the space
How can B.Protocol solve this?
A backstop is kind of a buffer that amplifies the available DEX liquidity
Instead of dumping into the DEX liquidity, it begins with the backstop pool
The collateral seized from the liquidation is then gradually rebalanced so as not to create a price impact that causes the slippage
For DEX like Uniswap v2, you need high liquidity in the pool to liquidate small amounts e.g. Even with a $100 mil liquidity in a USDC pool, $5 mil will cause a slippage of up to 5%
With a backstop pool, you just need a $5 mil liquidation with a $5 mil pool
With better liquidations, platforms can offer
A better safety net for the lenders to get their assets back from the borrowers
Borrowers can get better collateral factors to increase capital efficiency i.e. you can borrow more for the same collateral you put up
B.Protocol as an important middleware layer
They are putting a lot of effort to educate users and lending platforms
They want to reach a point where users will demand smart contract audits i.e. every platform knows that they need to audit their contracts before launching
B.Protocol as a mandatory risk management system before launching any platform
Together with 1kx, they are launching Risk DAO to promote education and transparency and also to provide research and risk assessments for DeFi lending and borrowing protocols
Set up a “Bad Debt” dashboard so users can check the bad debts of their different lending platforms
Give users a better idea of who is taking liquidation practices seriously
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