What Is Liquidation in Cryptocurrency?
Liquidation refers to the process of selling an asset that was used as collateral for a borrowing. In the context of cryptocurrency, liquidation can be triggered when the value of the underlying asset falls below the required amount of collateral.
This can happen in a number of ways, including market fluctuations, technical analysis signals, or unexpected events such as hacks or regulatory changes.
What is Collateral?
Collateral refers to the assets that are used as security for a borrowing. In cryptocurrency, collateral can be any digital asset that has value on a blockchain network. Common types of collateral include Bitcoin (BTC), Ethereum (ETH), and other popular cryptocurrencies.
When you take out a loan in cryptocurrency, the lender typically requires you to provide a certain amount of collateral as security for the borrowing. The amount of collateral required will depend on factors such as the type of loan, your creditworthiness, and market conditions.
How Liquidation Works
When you use cryptocurrency as collateral for a borrowing, the lender will typically require you to maintain a minimum value of collateral throughout the life of the loan. This is known as a “collateralization ratio.” If the value of your collateral falls below this ratio, the lender may trigger liquidation to cover their losses.
Liquidation can happen in a number of ways, depending on the type of loan and the terms of the agreement. For example, if you have taken out a margin trading loan, the lender may automatically sell your collateral if it falls below the required margin call level. Similarly, if you have taken out a leveraged yield farming loan, the lender may trigger liquidation if the value of your collateral falls below a certain threshold or if market conditions become unfavorable.
Real-Life Examples
Let’s take a look at a few real-life examples to help illustrate how liquidation works in practice:
Margin Trading
In 2018, the cryptocurrency market experienced a sharp selloff, causing many traders to receive margin calls and triggering widespread liquidations. One example of this was the case of QuadrigaCX, a Canadian cryptocurrency exchange that had to liquidate its users’ collateral after its founder died unexpectedly and left no record of his private keys.
Leveraged Yield Farming
In 2021, a popular decentralized finance (DeFi) platform called Convex Finance suffered a major security breach that allowed attackers to steal $375 million worth of cryptocurrency. As a result, many of the platform’s users were forced to liquidate their collateral in order to cover their losses.
Risks of Liquidation
While liquidation can be a useful tool for managing risk in cryptocurrency markets, it is not without its risks. Here are some of the most common risks associated with liquidation:
- Loss of Value: If you have used cryptocurrency as collateral for a borrowing, you run the risk of losing value if the price of the underlying asset falls below the required collateralization ratio. This can happen due to market fluctuations or other unforeseen events.
- Counterparty Risk: When you take out a loan in cryptocurrency, you are relying on the good faith and financial stability of your counterparty (i.e., the lender). If the lender goes bankrupt or experiences other financial difficulties, they may not be able to fulfill their obligations under the borrowing agreement.
- Lack of Transparency: Because cryptocurrency transactions can be anonymous and difficult to trace, it can be challenging to determine the true value of the collateral being used as security for a loan. This lack of transparency can make it difficult to assess the risk associated with liquidation.
