DeFi Darwinism

This rapid development has led to a DeFi arms race in which progressively more complex products, protocols, and platforms are developed to either overcome inadequacies present in DeFi ecosystems or, in most cases, profit from them. The current state of liquidation within DeFi protocols is a key example of DeFi Darwinism. 

Higher orders of complexity present within DeFi result in the evolution of predatory actors that aim to exploit or profit from system inefficiencies. The manner in which collateral is managed presents an opportunity for predatory actors that possess a deep understanding of how value flows within DeFi markets to extract value from them.

The DeFi ecosystem, at a fundamental level — and, like any debt market —is powered by asset collateralization. The decentralized nature of DeFi demands the over-collateralization of a position a priori, resulting in collateralization levels that average between 150 and 200 percent.

A DeFi user may, for example, choose to take out a loan on a DeFi lending protocol on the speculative prediction that favorable market action will generate profit upon the settlement of the loan. 

Should the market value of the collateral asset fall below a certain level, however, it’s likely that the borrowers’ collateral will be liquidated. How, though, is DeFi collateral liquidated?

Examining the mechanism through which liquidations occur within DeFi ecosystems reveals a surprisingly large but overlooked network of actors. Liquidators, while critical to the operation of many DeFi lending protocols, are able to participate in DeFi debt markets with functionally zero capital investment.

For example:

• • A DeFi user takes out a loan on a lending protocol using digital assets as collateral
  • The value of the digital assets used as collateral is significantly higher than that of the loan principal
  • The market value of collateral assets falls below the liquidation threshold of the lending protocol
  • The protocol then allows a third party to “purchase” the debt at, in most cases, a discount
  • This liquidator — the third party — takes ownership of the collateral assets

DeFi loans are critically different from other forms of collateralized lending in that they are executed on-chain. Transactions executed on almost any major blockchain network require the payment of a transaction fee. DeFi borrowers may not in some cases incur any financial cost if their collateral is liquidated, so DeFi protocols must incorporate mechanisms that incentivize liquidators to purchase collateralized assets that are liquidated in order to keep the system solvent. 

In most cases, these mechanisms take the form of liquidation fees and, in almost all cases, provide liquidators with the opportunity to capitalize on what are functionally significant discounts on collateral assets — yielding significant profits.

Blockchain maximalists purport that blockchain technology is intrinsically resistant to manipulation, citing the immutable and transparent nature of Nakamoto Consensus. Manipulation and collusion, however, are not restricted solely to the realm of ledger entries.

There exists today significant evidence and real-world examples of collusion in many blockchain-based systems. Empirical studies assessing substantial amounts of data collected through the observation of MakerDAO’s decision-making process indicate that voting power can be centralized within the hands of a small number of key decision-makers even in blockchain-based voting structures designed to restrict the unequal distribution of voting power.

Collusion within blockchain-based systems isn’t limited to the centralization of power through the exploitation of tokenomic or consensus mechanism design. In many cases, highly networked individuals work either as or with developers in major blockchain protocols to take advantage of otherwise-unavailable efficiencies that provide them with the opportunity to extract value from DeFi protocols in front of others.

Liquidation within DeFi is a highly profitable business —a single liquidation can, in some instances, generate up to $250,000 for liquidators. DeFi liquidators may provide a critical service within DeFi ecosystems, but currently extract a significant amount of value from the overall DeFi market. This overlooked profit opportunity can present liquidators with an incentive to act in a manner contrary to the core ethos of blockchain technology and DeFi, reducing the profitability of DeFi ecosystems for users.

Where is the evidence, though, that corruption in DeFi liquidation ecosystems exists? In order to identify collusion or corruption within DeFi lending markets, it’s necessary to understand how DeFi liquidators identity and act on liquidation opportunities. 

DeFi liquidators typically operate across a wide range of different protocols, through a broad spectrum of mechanisms and strategies. All liquidators follow the same basic modus operandi, however, which requires the following components:

• • A liquidator must operate a bot that monitors blockchain networks for pending transactions to identify DeFi loans that are eligible for potential liquidation
  • Liquidators must possess access to a means that facilitates the instantaneous disposal of liquidated collateral, such as a DEX
  • A smart contract that facilitates the instant liquidation and sale of collateral in the same transaction

In some cases, DeFi protocols may provide liquidators with baked-in tools that provide the functionality outlined above. In most cases, however, liquidators rely on a complex self-assembled ecosystem of liquidation bots. Insider advantages, however, can provide liquidators with the ability to harvest even greater profits — at the cost of retail DeFi investor capital.

Access to protocol-level intimacy with DeFi lending platforms can and does occur. Bank of International Settlements (BIS) analyses conducted on DeFi risks and the decentralization illusion identifies notable concentration and collusion risks present, citing endemic front-running within DeFi ecosystems.

The current configuration of liquidation within the DeFi landscape represents a significant capital flow from DeFi protocols, which typically operate in order to provide users and participants with the best possible return, into the hands of third-party liquidators. 

There are many examples of DeFi protocols that aim to recirculate generated value back into the protocol itself. Few protocols, however, address the growing issue of value erosion through liquidation — largely due to the critical nature of liquidators themselves to the operation of the DeFi ecosystem.

The evolving nature of the DeFi has seen innovation and development on both sides of the fence — Minterest, for example, addresses the predatory nature of DeFi liquidations by establishing a DeFi protocol in which liquidations are handled through an innovative auto-liquidation engine. Rather than leave liquidation in the hands of third parties seeking to extract value from DeFi ecosystems, Minterest captures liquidation fees and redirects them back to Minterest users.

The architecture of the Minterest protocol challenges the current DeFi paradigm by transferring value that would otherwise be lost to third parties back into the MNT token. In addition to operating as a governance token, MNT functions as a vehicle through which recaptured liquidation fee value is used to repurchase native Minterest tokens on-market, ensuring evaporated capital is returned to Minterest users.

Flashbots, on the other hand, represents a more complex technical approach to the democratization of value generated within DeFi ecosystems, bringing transparency and sustainable distribution to MEV — of which DeFi liquidation is a minor faucet. Rather than refine existing practices, Flashbots aims to restructure the manner in which block building itself occurs.    

By approaching DeFi from a holistic perspective with the primary objective of recirculating lost value back into a core protocol, newer generations of blockchain and DeFi protocols are able to offer users truly decentralized finance that excludes predatory liquidators, mempool snipers, and other forms of malignantly-competitive ecosystem participants.

Feel free to reach out with comments or questions regarding this article on Telegram @SamuelTown. If you’re currently in the process of launching a DeFI protocol or blockchain venture and are in need of a content strategist or marketing mercenary, get in touch today.