Aave Under Collateralized Loans and Failed Liquidations

There is no doubt that the recent Defi boom is fuelled by a lending & borrowing economy that has empowered anyone to get a loan instantly and without the intervention of any human being or paper work. It is estimated from Defi Pulse that approximately 82% of the total amount locked in Defi is allocated to lending protocols. The collateralized loans in Defi are the backbone of open lending protocols. The fact that DeFi enables open finance and pseudoanonymous transactions means that no one has a credit score or a formal identification associated with the loan they are taking out. Thus, as with mortgage loans, Defi applications will require borrowers to pledge collateral as an incentive to ensure that they can be held accountable for their debt repayment.
If, for example, the borrower were to default on the loan or if the collateralization ratio of a loan dropped below a threshold, then the borrower’s assets would be automatically liquidated and the debt would be repaid. These smart contracts are known in the lending industry as Liquidation Bots, and they are operated mainly by third parties through lending platforms. These third party liquidators are incentivized to participate in the ecosystem and automatically liquidate under collateralized loans.
We’re gonna talk about the incentives for liquidators, when they refuse to liquidate collateralized loans, and how many such under collateralized loans there are in AAVE V2.

Incentives For Liquidators

When a borrower fails to repay their loans, the assets of the borrower are auctioned by Liquidators and the loans are repaid. Also a percentage of assets from these auction are given as incentive to Liquidators. This is called as Liquidation bonus and it is one of the major incentives for Liquidators to participate in Lending Platform. On Aave v2, the Liquidation bonus range anywhere from 4% to 10% depending on the type of asset pledge as collateral. You can find the current liquidation bonus over here

In the event that a borrower fails to repay their loans, the assets of the borrower are sold at an auction and the loans are repaid. A percentage of assets from these auctions are also given to liquidators as incentives. This is known as a Liquidation Bonus, and it is one of the major incentives for Liquidators to participate in the Lending Platform. AAVE v2 offers liquidation bonuses ranging from 4% to 10%, based on the type of collateral pledged. The current liquidation bonus can be found here.

Calculating Liquidation Profitability vs Ethereum Gas Cost

The liquidators calculate the profitability of an under collateralized loan before liquidating it if its health factor drops below 1. As Ethereum’s network usage has spiked recently, the profitability of a liquidity bot is directly impacted by the gas price. According to AAVE documentation, here is a simple formula for calculating the profitability of liquidating an undercollateralized loan:

  1. Store and retrieve each collateral’s relevant details such as address, decimals used, and liquidation bonus as listed here.
  2. Get the user’s collateral balance (aTokenBalance).
  3. Get the asset’s price according to the Aave’s oracle contract (getAssetPrice()).
  4. The maximum collateral bonus you can receive will be the collateral balance (2) multiplied by the liquidation bonus (1) multiplied by the collateral asset’s price in ETH (3). Note that for assets such as USDC, the number of decimals are different from other assets.
  5. The maximum cost of your transaction will be your gas price multiplied by the amount of gas used. You should be able to get a good estimation of the gas amount used by calling estimateGas via your web3 provider.
  6. Your approximate profit will be the value of the collateral bonus (4) minus the cost of your transaction (5).

After running through these calculations, if an under-collateralized loan is deemed profitable then the liquidation bot will automatically liquidate it. Liquidators will not liquidate collateralized loans if they cannot see profitability in liquidating them!

A look at failed liquidations and undercollateralized loans using the Flipside Crypto Data Warehouse

With the data available via the Flipside Crypto Data Warehouse, we analysed the loans that are not liquidated by Liquidators due to high gas prices and were surprised to learn that there are 127 under collateralized loans on AAVE with a total amount owed of 510K.

Among the 127 collateralized loans, the top 3 loans account for 78% or 403K debt and the remaining 124 loans account for 107K liquidations that failed.

So what is the collateral available in Aave for that 510K dollars worth of under collateralized loans? As on Nov 19th the value of collateral is around 307.95k. That’s 200,000 US Dollars or about 39% of borrowed amount is under water!

The following chart shows all users whose assets have not been liquidated by liquidation bots due to their unprofitability. Two of the customers owe more than 200K, and the third customer owes 11,000 USD. By hovering over the bubbles, you will be able to see the total amount borrowed as well as their current collateral value.

The chart below shows the top 5 loans in order of borrowed amount along with their current health factor. Due to the large difference between the borrowed amounts of the five largest loans and the rest, we were unable to fit the rest of the 122 loans. Don’t worry, they are shown in a separate chart.

The following chart shows the rest of the 122 under collateralized loans along with their health factors.


I was assuming that all loans in Defi are automatically liquidated if they are undercollateralized, but this post breaks my assumptions. Crypto loans are also not always liquidated the same way that collateralized loans are not always liquidated in the real world. The leading defi application in the crypto market, Ave, has about half a million dollars of defaulted loans that are yet to be repaid. The liquidation bots do not want to liquidate loans if they do not see any profit in doing so. Their profits tend to be diluted most of the time because of high gas prices and other times because of sudden drops in asset prices. These failed liquidations have resulted in assets being worth less, particularly if the asset value is in free fall due to corrections in the market or the asset losing its value for a variety of reasons, such as investor not believing in the future value of the asset.

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