Lesson 3 - Liquidation Risk in Leveraged Yield Farming
Today, we’ll take a closer look into liquidation, demystifying the concept to make it simpler to understand. But first, let’s recap a few terms that will be used in the next section:
- Your Debt Value is the value of the borrowed tokens - Your Position Value is the value of your farming position, which is equal to your collateral + borrowed assets + yields (also known as the value of your LP tokens) - The Debt Ratio is your Debt Value divided by the Position Value - Your Equity Value is your Position Value minus your Debt Value (All values above are displayed in the borrowed token)
As senior alpacas, it’s our duty to teach you younglings about any risks at the farm, of which the most common is liquidation. So what is that? Well, when you open a leveraged position, borrowing up to 6x the funds you add, the protocol needs to make sure you’ll be able to pay back that loan. So the amount you add from your funds acts as collateral, which grows as you accumulate yields(minus borrowing interest).
That collateral has to remain above the amount you owe (plus a margin of safety to account for potentially quick price movements) or the protocol may close your position to pay back lenders, which is called liquidation. You want to avoid liquidation because at that time, 5% of your remaining position value would be paid to the liquidator bot as a reward for closing your position and ensuring lenders were paid back.
Now, let’s be clear. Liquidation is a risk, but only at certain times. When you first open a position, you typically do not have to worry about liquidation.
So when would you have to worry about it? Well, since you’ve deposited crypto tokens, the value of your collateral is volatile, able to change as token prices move. What’s more is that when you borrow funds, you are holding them and taking on the potential gains(and losses) of those assets while your position remains open.
Now, it’s important to note that another term for your collateral is Equity Value. It’s that equity value that needs to stay above a certain threshold to avoid liquidation. To be specific, if your Debt Ratio exceeds a threshold called the Liquidation Threshold, your position could be liquidated by a liquidation bot — meaning the bot would close your position, repay the debt, and return the remaining amount to you (denominated in the borrowed tokens).
Why would you get liquidated at the liquidation threshold? Because that’s when your collateral(equity value) has become low enough that if it continues to drop in value, there may be some risk that you couldn’t pay back your loan. So liquidation is necessary to protect Lenders. It’s what gives lenders the confidence to lend their assets to you in the first place, so you can farm profitably.
So that’s the general overview of liquidation. However, as leveraged farmers and investors, we’re mostly concerned about price. So let’s go into that next, putting liquidation in perspective with asset prices.
We have calculated these numbers and can tell you! Say you open a TOKEN1-TOKEN2 position and borrow TOKEN2 at 2x, 2.5x, or 3x leverage. Your initial Debt Ratio will be 50%, 60%, and 66.7%, respectively. For liquidation to occur, the price of TOKEN1 against TOKEN2 (TOKEN1/TOKEN2) will have to drop by 61%, 44%, and 31%, respectively, assuming a Liquidation Threshold of 80% (Table 1).
That makes it a lot easier to understand, right? When the tokens you are holding significantly drop in value, your collateral has dropped in value, and you need to be wary of potential liquidation.
(To view these figures with other leverage levels and Liquidation Thresholds, download our Yield Farming Calculator, go to the “LP Farming Liquidation” sheet, and play around with your desired inputs.)
After opening a position, prices can move and your Debt Ratio will change. Simply find your new Debt Ratio in the graph below to see how much (TOKEN1/TOKEN2) needs to drop before being liquidated. We also provide these numbers if you hover your mouse over the green Safety Buffer bar in the Your Positions section, so you can track your liquidation risk in real-time.
For single-asset leveraged yield farming, liquidations can also occur. Say you open a CAKE single-asset farm and borrow TOKEN2 at 1.5x, 2x, and 2.5x leverage. For liquidation to occur, the price of CAKE against your borrowed token (CAKE/TOKEN2) will have to drop 58%, 38%, and 25%, respectively (see table and graph below).
- 1.Alice opens a BNB-BUSD yield farming position using 3x leverage
- 2.She supplies 10 BNB of her own assets(worth 3000 BUSD), which is her Equity Value.
- 3.She borrows 6000 BUSD (3x what she supplied)
- 4.The protocol then converts all deposited and borrowed tokens into a 50:50 proportion for creating the LP tokens for farming: 15 BNB + 4500 BUSD or 30 BNB worth, which is her Position Value. (In reality, it would be slightly lower due to price impact from swapping and trading fees. Alice’s net exposure is long 15 BNB.)
- 5.Alice’s Debt Ratio (Debt / Position Value) is ~66% (20 BNB / 30 BNB)
- 6.If at some point, BNB price drops > 36%(calculated using the Yield Farming Calculator), then Alice’s Debt Ratio will exceed 83.3% (the Liquidation Threshold for the BNB-BUSD pool). A liquidation bot would then call the smart contract to close her position, repay the loan, and return any remaining assets to her wallet.
Please note that this example ignores the impact of yield farming rewards and trading fees which over time, would increase Alice’s position value and make her position safer. It also ignores the borrowing interest rate which would increase the debt value, moving her debt ratio higher.
That’s the gist of how liquidation works. So how can you avoid liquidation?
Here are a few things you can do to avoid liquidation.
- Monitor your Safety Buffer: The Safety Buffer in the Your Positions dashboard tells you how close you are to potential liquidation. Once it reaches zero, you can be liquidated. You can also scroll over it to see how much your primary asset has to drop in price for the safety buffer to reach zero.
- Add collateral: If you see your Safety Buffer dropping, you can choose to add collateral, the button to the right of your open position, in order to increase your safety buffer and avoid liquidation.
- Farm less volatile assets: If you’re farming stablecoins, liquidation becomes extremely unlikely. What’s more is farming less volatile, high market cap assets like BTCB is safer than new low-cap tokens. Of course, the trade-off here is you earn smaller APYs.