Liquidators: The Secret Whales Helping DeFi Function

In his first piece for Dragonfly Research, Tom Schmidt examined the role liquidators play in decentralized credit markets. As all loans are required to be over-collateralized, a system needs to be in place to prevent borrowers from running away with their loan if their collateral falls below the loan value. Before this can happen, once the collateral value falls below a certain threshold (always >100% of the loan value), any user can repay the loan for the borrower in return for the collateral plus some liquidation fee.

Liquidators are similar to miners in that they perform useful services for the network and are compensated based on encoded rules. To date, this has been a profitable activity for many, earning nearly $1 million last year. However, there are several factors leading to decreased profit margins:

• Low barriers to entry means increased competitions will enter the market
• Borrowers are getting better at finding ways to more efficiently manage loans such as using DeFi saver or Aave's flash loans that can be used to avoid paying the liquidation fee
• MakerDAO moved away from a fixed price sale of collateral to an auction in multi collateral dai opening the liquidation fee to a competitive market. This will

Why it matters

• These developments leading to lower borrowing fees will make for an improved DeFi user experience at the cost of lower margins for liquidators, although the former could help bring in additional capital leading to more aggregate fees for liquidators.
• As more use cases for decentralized finance emerge, more applications such as synthetic assets and derivate platforms will require third parties to provide value-add services and be compensated for their work.