Liquidators: The Secret Whales Helping DeFi Function
Brother, Can You Spare a Gwei?“There’s not a repo bot alive that doesn’t use gas tokens, kid”
Liquidators are underexamined actors in the DeFi space, working, like miners and validators, behind the scenes to keep the entire system functioning and being handsomely rewarded for doing so. Unlike miners and validators, however, liquidators require effectively no upfront capital investment, creating an ecosystem of professionals operating from potentially anywhere in the world, entirely anonymously, getting paid to keep markets solvent.What are Liquidations?
Over the past two years, a number of decentralized lending protocols, including MakerDAO, Compound, dYdX, and others, have launched on Ethereum, allowing anyone to trustlessly lend or borrow cryptoassets. While these protocols vary in go-to-market approach, assets offered, loan terms, etc., the fundamental loan structure is the same. The borrower places collateral in a smart contract and, in return, is allowed to borrow some lesser amount of another asset provided by the lender. This form of secured lending is one of the most primitive financial instruments, dating back to Venetian banking in the Middle Ages, and contrasts with unsecured, credit-based lending that consumers are more familiar with.
Secured loans can work well when the value of the collateral exceeds the value of the loan, giving borrowers access to working capital without needing to sell their often less liquid assets. However, when the value of the collateral drops, rational borrowers are now incentivized to abscond with the loaned asset, leaving lenders potentially underwater. After all, why return 100 DAI to get back $99 of ETH? With more traditional forms of secured lending, such as auto title loans or mortgages, this is not an issue as the value of those assets are typically less volatile than cryptoassets. However, when taking out a loan with e.g. ETH as c...