1. What is a margin call?
In traditional markets, trading with borrowed money is called borrowing on margin. Lenders, usually brokers, require collateral, usually in the form of other equity, to be posted to offset the risk of the transaction going wrong. The collateral requirement is defined as a percentage of the loan. This means that if the value of the collateral drops, the broker will ask the investor to deposit more collateral or close the position and repay the loan.
2. How can margin calls disrupt markets?
The system generally works quite well when the markets are rising or roughly flat, although individual investors who make bad bets or get in over their heads may suffer. Bigger problems can arise when there is a significant drop in values that triggers widespread margin calls. When investors sell holdings to achieve a margin, they drive prices down further, causing further margin calls.
3. How is it different in crypto?
For one thing, the DeFi (decentralized finance) applications on which many crypto exchanges take place tend to be interconnected, meaning that problems in one can have cascading effects on the other. On the other hand, most DeFi applications require over-collateralisation – that an amount of crypto greater than the loan is displayed, to account for the normal volatility seen in this market. But perhaps most importantly, the liquidation of positions when margin calls are not met usually happens automatically: the so-called smart contracts used to execute trades will pass the positions to robots designed for this purpose. There is no chance of convincing a broker that you will be able to hedge your position if they give you an extra day, hour or minute.
4. What happens when liquidations are triggered?
Many DeFi apps offer a liquidation bonus to bots, which are run by third-party programmers and traders. This incentive can lead to swarms of them competing to perform the liquidations, a situation that can clog blockchain ledgers used to process and record crypto transactions. And as with any other type of margin call, a large number of liquidations – or the liquidation of a large holding company – can drive down token prices, leading to more liquidations.
5. How bad is the situation?
The pain now rocking DeFi apps was sparked after centralized crypto lenders Celsius Network and Babel froze deposits and the rumored collapse of the Three Arrows Capital fund sent crypto prices down double digits in the US. one week course. Celsius had worked with many DeFi applications to achieve the high returns it offered. Much of the market turmoil has centered around stETH, a token that represents staked Ether on the Ethereum blockchain and counts Celsius as a major holder. Since its launch by decentralized app Lido Finance, stETH has become one of the most popular collateral assets for lending and borrowing in DeFi. But stETH began trading at an increasingly deep discount to the price of Ether, which led to both liquidations and illiquidity in its trading. About 30% of all stEth stuck on Aave, for example, came from Celsius, according to researcher Novum Insights. Three Arrows Capital, meanwhile, was an investor in Lido, which issued stETh. As tracked by DeFi Llama, the total value locked in DeFi, the amount of crypto used on apps, plunged to $76 billion on June 24 from $205.7 billion on May 5, just before the implosion of the Terra blockchain triggers the biggest crypto crisis of the year. far.
6. What was the response?
Some unprecedented measures have been taken, although some of them have been reversed. On June 19, tokenholders of Solend, a lending application on the Solana blockchain, voted to temporarily take over the account of a large user who was facing the threat of a large liquidation, an extreme move for DeFi that seemed like a first. The move, which was intended to provide an orderly OTC liquidation rather than a robot-driven fire sale, was overturned in a follow-up vote. Many other apps have moved to adjust their practices and policies to avoid large-scale liquidations and the resulting losses.
7. What is the meaning of all this?
During the bull market, many crypto traders seemed to have forgotten how risky crypto lending and DeFi in particular can be. The wave of liquidations sweeping through the industry seemed to prompt more people to become more cautious about borrowing. On the decentralized exchange dYdX, for example, traders have significantly reduced their leverage since the Terra crash.
• Bloomberg QuickTakes on DeFi, Crypto Lending, Terra Implosion, Yield Farming and Stablecoins.
• A CoinDesk article on $1 billion in crypto liquidations.
• A Bloomberg article on Solend votes and other DeFi app moves on liquidations.
• An introduction to DeFi liquidations from Ledger Academy.
More stories like this are available at bloomberg.com
