When a user borrows from a DeFi protocol, he should provide collateral which is usually worth more than the borrowed amount. There is a metric called collateral ratio – the value of the collateral divided by the borrowed amount – (CR) which varies across DeFi protocols (with a wide range of ~108% - 170%). If the collateral depreciates in value and the actual CR falls below the minimum required threshold, the position becomes liquidatable. Liquidation is the process of the sale of part or all of the borrower’s collateral. This is done to repay the borrowed funds to the protocol. Liquidation is triggered by users called liquidators. They repay for the debt of the position and in turn are eligible to acquire part of the collateral. They are incentivized to do liquidation because they buy collateral at discount, i.e., repaid value is less than the value of the collateral.
Liquidation is a double-edged sword of DeFi. Although it may be considered bad from the point of view of borrowers, liquidation has been designed to protect lenders, protocols, and platforms. In crypto, where price swings can be wild, liquidation is a necessary mechanism for ensuring the health and stability of the system. Selling a sufficient amount of collateral protects lenders’ capital thus ensuring the stability of the system and incentivizing users to lend their surplus capital. On the other hand, massive selling of collateral decreases asset prices which lead to further liquidations and cause a system-wide crash.
Some solutions have already been suggested to deal with the problem of liquidation.
- Dutch auction liquidations
- Partial liquidations
- Non-linear rewards
Dutch auction is a descending-price type of auction where an auctioneer offers a very high price. This is the price at which there is likely to be no buyer. The auctioneer incrementally decreases the price until there is someone willing to buy the item. When a buyer places a bid matching the offer price, he wins the item, and the auction concludes. The fact the first buyer (bidder) wins the sold item prevents the bidding war. This is in itself a good design compared to a traditional auction because it results in an efficient a fast price discovery without slowing down the process. As such Dutch auctions have been used to sell perishable products which are needed to be sold fast, such as fresh flowers or fish.
Orca is the first public marketplace to bid on liquidated collateral. Built on Kujira, the d’App allows users to bid on liquidated collateral with various tokens, from ARB to UNI. Participating in a Dutch auction users can buy collateral at a discount, which at the time of the writing can be maximum 30%.
To avoid immediate selling Orca employs “a queue-based and anti-bot approach” – the bids with the smallest discounts are filled first. Let’s say, there are two bids on liquidated collateral which is worth 100 ATOM. User A wants to buy collateral at 30% discount paying only 70 ATOM. User B, on the other hand, is willing to pay 95 ATOM, i.e., his bid is to buy the collateral at a 5% discount. Since his discount is smallest of the two, B’s bid will be filled first, all other things being equal. This leads to an optimal discount rate and, as already mentioned, avoids quick selling by MEV bots. Immediate selling has a deleterious effect on the market by depressing the prices of assets that have already decreased. By first filling the bids with the smallest discounts, Orca disincentivizes bots and encourages community members to acquire liquidated collateral at a discount to support long-term success of the projects.
