Clear and Present: DeFi Liquidations Highlight Need for More Education and Better Solutions

Lending and leveraging have long been cornerstones of DeFi. In fact, during the first DeFi bull run lending/borrowing was its biggest primitive, the rocket fuel that saw TVL soar past $190 million. Fast-forward a few years and the bulls are gaining momentum again, with Total Value Locked recently crossing $100 million. Though liquid staking has become the dominant play, lending continues to be responsible for over a third of all value locked.

The allure of high yields and insane profits is undeniable, so don't expect these protocols to lose their appeal. Beneath the surface of such lucrative opportunities, though, lies a significant risk: liquidation. Liquidation is the ugly word no-one in crypto wants to talk about: it's analogous to firefighters chatting endlessly about playing cards at the station yet never referencing the frequent infernos they must tackle.

Earlier this month, a fall in the price of bitcoin provoked a cascade of liquidations, forcibly closing $1 billion worth of leveraged derivatives positions. Late last year, another period of volatility in the BTC market triggered liquidations worth over $300 million in one 24-hour period, with 77,548 traders burned.

Is liquidation simply the price of doing business, the risk that must remain to teach traders important market lessons? Or should we be consciously promoting educational resources and solutions to help prevent their occurrence?

Understanding DeFi Liquidation Risk

Liquidation occurs when a user's position is automatically closed out due to insufficient margin to cover their leveraged positions. This is a common scenario in crypto lending, where borrowers deposit crypto as collateral for a loan; if the value of this collateral falls below a certain threshold, the loan is auto-liquidated, resulting in 'forcible closure' and the loss of the collateral.

This risk is further amplified in leverage trading, as we can see from recent market data: aggregate open interest on centralized exchange (CEX) Bitcoin derivatives, which can be leveraged up to 100x, has jumped nearly 90% since October. Liquidations in this context occur when a trader fails to meet margin requirements, typically due to a movement in the price of assets they're longing/shorting.

The extent to which liquidation mechanisms are understood or, at any rate, given the contemplation they merit, is difficult to say. However, it is patently obvious that liquidation remains a clear and present danger for traders, particularly during periods of unexpected market turbulence.

Nolus: A New Approach to Mitigating DeFi Liquidation Risk

In this milieu, the emergence of Nolus is easy to understand. The protocol is designed to address DeFi's latent liquidation dangers, drawing inspiration from traditional leasing models to create a scenario wherein users pay only a fraction upfront and gain ownership after repayment. 

By instituting this process, Nolus helps to reduce the highly risky over-collateralization standards that have become the norm in DeFi, enhancing capital efficiency and offering borrowers more attractive loan terms.

Built by a core team boasting over 15 years' experience in TradFi, marketing, and product development, Nolus wants to be seen as a beacon of safety and efficiency in a landscape often described as a "Wild West." It's also notable for its emphasis on interoperability, connecting various liquidity sources across blockchains without fragmenting assets. 

Nolus' ability to facilitate the swapping of assets on any integrated decentralized exchange (DEX) is intended to simplify notoriously convoluted lending processes, eliminating the need for multiple pools and ensuring LPs deal only with stable assets.

In a sense, the protocol merges the best of TradFi and DeFi, creating a money market between lenders chasing yield on stablecoins and borrowers looking to leverage their equity. While borrowers make a down payment that can be leveraged by a factor of three, both the down payment and loan are stored in a smart contract as collateral.

Nolus's fixed borrower terms of interest during the lease contract ensures predictability for future cash flows and yield distributions and, because it operates on a cash basis model, lenders are rewarded with actual yield. Interest from DeFi Leases, meanwhile, is collected periodically: if unpaid, it's automatically deducted from active positions. The principal can remain unpaid, but in a downturn, a margin call will trigger partial liquidations to maintain a healthy level. 

Revenues from DeFi Leases on Nolus average at ~15% APR, with lenders receiving 11% in stablecoins. Amidst recent bull market fever, Nolus announced some major milestones: $25 million in transaction volume, a 72% increase since January; 6,739 loan grants; and $14.5 million in Leases, of which there are over 1,400 – with 84% and 40% ROI. Evidently, many users are realizing that liquidation risk is scary – and that alternatives can be remunerative.

Nolus aside, there are sound strategies for mitigating DeFi liquidation risk and educational resources out there to help fine-tune them. But it's fair to say many DeFi protocols pay lip service to liquidation risk, preferring to stay silent then shrug when users' hopes and dreams get extinguished. Don't say we didn't warn you. To avoid being wiped out, get familiar with the mechanisms that trigger liquidation and consider alternative protocols committed to reducing the burden.