Posted on Aug 03, 2022Read on Mirror.xyz

liquidati0ns reimagined

Firstly, what is a Liquidation?

Simply put, liquidations occur when a loan incurs too much debt.

In the event of a negative price fluctuation of the debt collateral (i.e., a move below the liquidation threshold), positions can be liquidated. The liquidation threshold is the percentage at which the collateral value is counted towards the borrowing capacity. Anyone can then repay the debt and claim the collateral.

Being a liquidator can be extremely profitable due to the Liquidation Spread bonus; or discount, that a liquidator can collect when liquidating collateral. This spread incentivizes liquidators to act promptly once a loan crosses the liquidation threshold.

Current Liquidation Systems:

(these three protocols represent 85% of Ethereum’s total lending market liquidity)


The Compound liquidation process relies on 3rd party liquidator bots to keep the protocol in balance. It incentivizes participants with an 8% fixed discount to liquidate the collateral as quickly as possible via a first-come-first-serve system. Miners abuse the system by moving the liquidation incentives into gas costs.


AAVE’s liquidation system works essentially identically to Compound’s with two differences. Firstly, the liquidation penalty varies depending on the asset used and ranges from 5 to 15%. Secondly, AAVE introduced an additional liquidation threshold, a safety leeway, on top of the maximum loan-to-value ratio, which also varies from asset to asset.


dYdX’s liquidation process is again similar to Compound’s, but differs in that dYdX does not expose a tokenized interface to its lending protocol like how Compound does through its cTokens. Instead, dYdX creates a series of trading accounts for each address within its main Solo Margin contract, and tracks the credits and debts of each account on each market it supports (ETH, DAI, USDC, etc.).

Problems in current liquidation systems

Over $6B in DeFi assets crucially relies on an adequate liquidation process for their security. The Dai ecosystem, lending platforms like Compound and AAVE, synthetic asset platforms, and margin trading platforms all rely on liquidations to remain solvent.

One of the foremost issues is the MEV wars role in liquidations:

Average Gas utilized on AAVE, Compound, and dYdX

A recent academic study predicts that as the DeFi volume increases, the equivalent of the entire discount on the collateral will be spent on miner fees through FCFS gas price auctions. This means miners are currently extracting value that users otherwise could be profiting from, which bears out in analytics of the millions of dollars being taken from users by miners.

The second issue is reliance on mercenary liquidators and the lack of on-hand liquidity to quickly dispense debt. This concern is not only academic. The recent events of “Black Thursday” in March 2020, in which MakerDAO liquidators failed to secure over $8M of funds, showed that a lack of commitment would inevitably lead to default events. Moreover, the lack of commitment and on-chain feedback from the liquidator side makes it difficult to price the desired liquidation premium, leading to paying very high premiums on DeFi platforms.

The third issue is asset/protocol stability. For example, Anchor Protocol and Luna’s dizzying crash were heavily correlated with a $1b in mass liquidations of LUNA on the protocol. Cascading Liquidations occur from liquidator bots settling liquidations and instantly selling the collateral purchased, causing further liquidations to occur from the drawdown in asset pricing from the sales. Events such as Maker’s “Black Thursday” have exposed how crucial liquidation systems are, especially in the situation of protocols that do not isolate CDPs as Tapioca does.

These issues have come into play even recently, with the top lending/borrowing protocol on Solana, Solend. Solend had a loan collateralized with 5.7m SOL (approx. $200m) that faced liquidation. Solend tried to enact emergency governance controls to try to settle the liquidation off-chain, as allowing the liquidation to occur would have halted the network from liquidator bots attempting to liquidate the loan or even make Solana’s DEXs illiquid from settling the sale of the SOL.

Another secondary issue is the centralization of the liquidation process. There have been a total of 418 liquidators up to 2021 of the three protocols, but the top 5 make up more than 57% of total liquidations, with the top 25 liquidators accounting for more than 91% of all liquidations. The largest liquidator handled more than $220M across the three protocols. On May 19th, 2020, of 5012 liquidations accounting for $377m USD, a single bot operator handled $220m of the total.

Enter Liquidation Auction Queue

Tapioca’s liquidation auction queue provides better asset stability and unlocks higher capital efficiency in DeFi. By democratizing liquidation systems we reclaim MEV and liquidator bot’s profits for our users.

Tapioca’s Liquidation Auction Queue creates a new queue-based liquidations system. This mechanism abandons the method of rewarding the few at the expense of the many and allows any user to bid on liquidated collateral, making the process truly democratic and decentralized, while also lowering the barrier for entry for many more participants to get involved with the profitable liquidation system. Most importantly, it creates a process that eliminates any advantages bots have, as well as taking profits from miners and placing them back in the user’s hands.

Discarding the old FCFS liquidation mechanism, Tapioca instead pays liquidator bots nothing. Using Gelato Network, Tapioca scans CDPs debt ratios, when loans incur too much debt, the CDP is sent for liquidation on an orderbook.

Users deposit common stablecoins into this orderbook (such as USDC, DAI, sUSD, and FRAX), and preselect the discount below the market value that they’re willing to purchase CDPs for. These bids are pooled into groups - 1% buckets - and when collateral is liquidated, priority is given to the bids in the pool with the smallest discount. As the liquidation auction queue becomes more liquid and competitive, discounts will fall and the effects liquidations have on assets will minimize. This also saves liquidated borrowers from large losses due to liquidators no longer buying their collateral for bargain bin prices.

Secondarily, capital efficiency and security are maximized with a constant source of liquidity to settle debt. Instead of relying on mercenary bot operators to continue coming back to pay off debts, Tapioca holds custody of funds to immediately settle debts. Users’ funds continue purchasing liquidations (thus profiting) until the user decides to pull the liquidity. Isolated CDPs remove any systemic risk to Tapioca at a protocol level, as well as users of the platform, from liquidations.