In recent months, cryptocurrency liquidations have dominated headlines in the crypto world. This article explains the concept of liquidation, why it occurs, and how to mitigate its risks.
Key takeaways:
- How cryptocurrency liquidations happen
- Causes of crypto liquidations
- Impact of liquidations on the crypto market
Understanding Cryptocurrency Liquidation
Cryptocurrency liquidation refers to the forced closure of leveraged positions when traders fail to meet margin requirements. This typically occurs in decentralized finance (DeFi) lending protocols like AAVE, MakerDAO, and Abracadabra.
👉 Learn how liquidation thresholds work
How Liquidation Works
- Traders use assets as collateral to borrow funds for leveraged trading.
- If the collateral value falls below a predetermined threshold (e.g., 150% collateralization ratio), the position is automatically liquidated.
- Liquidators purchase the collateral at a discount, creating selling pressure on the market.
Example:
On June 18, 2022, ETH's price drop triggered $424M in liquidations across DeFi protocols (Footprint Analytics data).
Why Do Cryptocurrency Liquidations Happen?
DeFi protocols implement liquidation mechanisms to maintain system stability. Let’s examine MakerDAO’s process:
- Collateralization Ratio: Minimum 150% (e.g., $150K ETH collateral for $100K DAI loan).
- Liquidation Trigger: If ETH drops below $1,500, the position enters liquidation.
- Penalties: 13% fee (3% to liquidators, 10% to the protocol).
👉 Avoid liquidation with these strategies
Prevention Tips:
- Borrow less than the maximum limit.
- Add more collateral before price drops.
- Repay loans proactively.
Market Impact of Liquidations
1. For Institutions
- Mass liquidations create cascading sell-offs (e.g., Celsius and Three Arrows Capital collapses).
- Triggers "death spirals" when protocols absorb losses from undercollateralized positions.
2. For DeFi Protocols
- TVL drops as users withdraw assets to avoid liquidation (57% decline in 90 days).
- Protocol insolvency risks increase under market stress.
3. For Users
- Loss of collateral + penalty fees (e.g., 13% in MakerDAO).
FAQ
Q: How can I check liquidation risks?
A: Monitor your collateralization ratio using DeFi dashboards like Footprint Analytics.
Q: Are liquidations avoidable?
A: Yes—maintain higher collateral buffers and avoid max borrowing.
Q: What happens after liquidation?
A: Liquidators sell discounted assets, increasing market volatility.
Conclusion
Cryptocurrency markets are cyclical. During downturns, manage leverage carefully to avoid liquidation spirals. Stay informed and adjust strategies to navigate volatility.
Footprint Analytics provides free blockchain data tools to track DeFi trends and liquidation events.
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