How DeFi Liquidators Make Money With Just Bots - Ep.109

Transcript

Hi everyone, welcome to Unconfirmed, the podcast that reveals how the marquee names in crypto are reacting to the week's top headlines and gets the inside scoop on what they see on the horizon. I'm your host, Laura Shin. eToro is one of the largest trading platforms in the world, with over $1 trillion in trading volume on the platform per year. U.S. customers can trade the most popular crypto assets with transparent fees. Create an account today at eToro.com. That's E-T-O-R-O dot com. Crypto.law, aka Kelman Law, is a New York law firm run by some of the first lawyers to enter crypto in 2013 with expertise in litigation, dispute resolution, and anti-money laundering. Email them at info at kelman.law. Crypto.com, the crypto super app that lets you buy, earn, and spend crypto in one place. Download the Crypto.com app today. Today's

guest is Tom Schmidt, Jr. Partner at Dragonfly Capital. Welcome, Tom. Hi, Laura. Thanks for having me on. You wrote an interesting post last week on the liquidators in DeFi. You call them the secret whales helping DeFi function. Can you give a synopsis of your post? Sure. So liquidators play an important role in the collateralized lending ecosystem, which has really been booming on DeFi in the past year or so. And actually, before you keep going, can you just define what liquidators are, who they are? Yeah, yeah, definitely. Liquidators repay under collateralized loans so that lenders get to remain solvent. And in turn for doing this, they get to collect a small bonus from the people who are borrowing and about to default on the

loans. So they play a really important role in making sure these protocols function as intended. And I keep going with the synopsis of your post. Sure. So liquidators, in short, help repay these under collateralized loans. or to make sure that lenders get repaid. And in doing so, get to collect a small fee, a small bonus for actually repaying these debts. And we've seen sort of a burgeoning ecosystem in the liquidator, or we've seen sort of a burgeoning ecosystem of liquidators form who are incentivized to help repay these loans because of these bonuses. So it started out pretty small with just a collection of different individuals liquidating undercolliders, MakerDAO CDPs. But since the launch of Compound and DYDX, which both also have liquidation

bonuses, we've seen almost $5 million in liquidation bonuses be collected by different liquidators over the past year. I think more broadly speaking, as with many different things in crypto and DeFi, the ecosystem has gotten a lot more sophisticated. We've seen people employ very complex strategies, very sophisticated pieces of code to out-compete each other to actually win these opportunities. It is a bit of a zero-sum game in a sense where once a debt actually gets liquidated, there's no more opportunity for someone else to come in and liquidate. So there's these huge opportunities out there to win basically free profit.

And as a result, we've seen sort of a arms escalation among liquidators to go and win this money. All right. So let's back up a bit and just kind of make sure that everybody who's listening to this is on the same page. Why don't we just walk through first how secured loans work and then get to the part on liquidators and how liquidations work. Just walk through, you can pick which protocol you want to do, but just walk through one example so we make sure people understand. Yeah, definitely. I walked through a couple of different flavors and implementations across the different protocols, including Maker, Compound, and DYDX in the post. But I think Compound is probably the most straightforward to understand. A typical secured loan looks something like

this. Someone who wants to borrow an asset, let's say they want to borrow USDC, they place some of another asset, let's say Ether, into a smart contract and are able to borrow a lesser amount of the other asset from a pool of lenders who have already deposited, let's say, that USDC into the contract. If I want to borrow USDC secured using my ether, I'll place $150 worth of ether into compounds contracts and then withdraw $100 worth of USDC. So at this point, there's more value secured in the contract than there is actually being borrowed by myself. And people might use this for a couple of different reasons. People use this to margin trade.

So you can get leverage if you use that USDC to buy ether. You can use this to liquidate other collateralized zones, for example, if you need to borrow a different type of asset, or maybe you just need to put some, you need some working capital that you can put to some productive use. So there's a couple of different reasons why people might go about borrowing this asset, but ultimately people are incentivized not to run away with this loan by the fact that there is a greater amount of their deposit still held in the smart contract. So I'm not going to run away with $100 to lose $150. Now, this equation sort of changes as, let's say, the value of the collateral starts to decrease. So as soon as the value of the Ether gets below $100, there's no sense in actually paying back that loan.

Why would I pay back $100 to get back $90, for example? And so this is where liquidators really come into play. They find those under-collateralized loans, so loans where maybe they're starting to approach that threshold where it might make sense for the borrowers to run away with the profit or run away with the borrowed asset. And basically take the collateral, some portion of the collateral from the borrower and repay the loan back, repay the borrowed asset back to the lender such that everyone remains solvent. No one is actually losing any money other than the borrower who was about to potentially default on their loan. And so why don't you maybe use like actual dollar amounts? So if you collateralized with $150 worth of ETH, you take out $100,

then the liquidation would happen at one point and how, at what point and how much would the borrower end up with and how much would the liquidator end up with? Just so we have, you know, dollar amounts to attach to this. Yeah, definitely. So the collateralization ratio actually varies across different types of assets and different types of protocols. So really high collateral or really high quality collateral might require a lower collateralization ratio than something that's maybe more volatile or more likely to fluctuate in value. So some pieces of collateral might require a 750% collateralization ratio, as is the case with something like synthetics. But something like Ether, which is a relatively good piece of collateral, a really high-quality piece of collateral, might only require 150% or

115% in some particular scenarios. So let's go back to a very simple scenario. borrower places $150 in collateral, $150 in Ether into a smart contract, and then is allowed to borrow $100 worth of DAI or USDC or some other type of asset in return. Now, this loan is considered solvent as long as they remain at this ratio, this 150% collateralization ratio. A lot of borrowers will actually place a larger amount of their collateral into the smart contract just so that if the price of Ether fluctuates or decreases momentarily, they're not at risk of being liquidated. So people might even place more than the required collateralization ratio. Now, let's say that the value

of the collateral falls below that 150%. So let's say that suddenly the value of that Ether that you placed in the smart contract now falls to $140. You're starting to approach that dangerous threshold where it might make sense for you to run away with the loan. And so at that point, these liquidators can find these potentially risky loans and make sure that lenders are being repaid what they're owed. So in this scenario, let's say that $100 in USDC, a liquidator can step in, pay that $100 in USDC back to the original lender so they remain solvent. There's no chance that they're going to lose their funds. And as a result, they're able to basically get a 5% discount or a 5% bonus from the collateral that you've placed. So in

this scenario, that might be them you know, buying, you know, $140 worth of Ether for a price of $130 or something to that effect. So they get this nice little bonus. You get to get the remainder of your collateral back. Basically, the liquidator takes a small, is able to purchase your collateral at a small discount. That's their bonus and their incentive for actually monitoring the state of Ethereum and making sure that these lenders remain solvent. And the liquidators aren't like literally watching this and trying to liquidate. They're like doing it in an automated fashion, right?

Yeah. There are a couple manual dashboards that have been set up where people can monitor and attempt to liquidate under collateralized loans. But I think in practice, what we see is the vast majority of liquidations are performed by bots. The same way, you know, you could in theory try to click arbitrage across different exchanges or different assets. But the vast majority of those opportunities also get eaten up by automated bots that are running 24 seven on a server somewhere. Great. Well, in a moment, we're going to discuss the future of liquidations. But first, a quick word from the sponsors who make this show possible. Crypto.com. Have you seen the MZO Visa card?

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work in the Mt. Gox civil rehabilitation. So if you operate a fintech business or have a dispute with some person or business involving crypto, or you just need legal advice related to crypto info at Kelman.law. That's K-E-L-M-A-N.law, or just go to their website at www.crypto.law. When you think crypto think Kelman. Back to my conversation with Tom Schmidt of Dragonfly Capital. So I can't remember, I feel like you might have mentioned how much liquidators made in DeFi last year. It was five million. It's not a huge amount, but do you feel like that's going to grow? And how many liquidators was that spread out over? Per liquidator, how much were they making? Yeah, that's another good question. I think the overall sort of

trend that we've seen in DeFi liquidations is a trend towards more competition. So We've seen almost seven times growth in the number of monthly active liquidators. These are individual addresses that are attempting to liquidate a loan every single month. We've seen a margin compression where every single liquidator is getting a smaller and smaller percentage of the total profits in the ecosystem. I think overall, we've just seen borrowers become a lot more savvy. There are fewer and fewer opportunities to actually liquidate these loans, because they're not even becoming under collateralized in the first place. So borrowers can, like I mentioned earlier, place some additional collateral ahead of time such that they remain above the required ratio. And they're employing tools like DeFi Saver, which will monitor their loans for

them. And in the event that they start to become under collateralized, unwind their loan by repaying their debt such that they aren't subject to this discount. So I think overall, we're seeing more competition for more and more sophisticated actors. And additionally, I think the TAM is starting to decrease as well, just given the fact that these borrowers are getting a lot savvier. I think going forward, there's also just some interesting opportunity on the outskirts, where a lot of people are excited by the prospect of under-collateralized loans or unsecured loans, which would be more credit-based. And so there wouldn't necessarily be a piece of collateral that would have to get liquidated. And so there's potentially competition from that coming in the next year. I think additionally, what we've seen is that

this opportunity is so appealing because of this large fixed discount, right? 5% of a multimillion dollar loan ends up being a pretty large chunk of change. But the system seems to be working as intended here. So maybe these systems can get away with a smaller discount or a smaller bonus such that the system can remain solvent without overly harshly you know, punishing these borrowers who are maybe close to default. And I think we've seen a couple different protocols pursue this more variable for your market based approach, such as Maker with their multi collateral die migration. So I think there's also just an opportunity to move to smaller and smaller margins or bonuses over time for these liquidators. And, you know, earlier when we talked about kind of the different protocols where this is happening in general, where do you feel like liquidation activity is greatest?

So interestingly, I think the majority of liquidation profit is coming from DYDX. I think this is for a couple of different reasons. One, they have a lower collateralization ratio than most other protocols. I believe on the low end, it's 115%. And I think on the other hand, these loans are often being used to margin trade at relatively high leverage points, so 4X or 5X leverage. So they tend to have more liquidations, which results in you know, a greater opportunity for liquidators. I think also there's just a question of tooling. Maker has some sort of default bots and some default tooling that you could run by yourself. DYDX also has some which are, I think, a lot more approachable and have been out for a bit longer. And as

a result, I think this has attracted sort of an ecosystem of people who are interested in liquidating on DYDX. So there's a couple different flavors to how people actually go about, you know, running their liquidation bots, but ultimately it requires some sort of code off-chain that's running and actually looking for potentially under-cloud-wise loans. But when you say that they have tooling for it, so it's not necessarily like hardcore developer types who can do this? It's more accessible than that? Yeah. In theory, anyone who can take a piece of code off of GitHub and deploy it on a server could potentially become a liquidator. And I think there's a growing appetite for something like this. I think, unfortunately, unless you have some sort of interesting edge

or some sort of alpha, it's going to be very difficult to actually make this profitable for yourself. So we've seen some of the more sophisticated liquidators employ strategies such as using gas tokens. So one of the largest costs for liquidators is just the fact that they have to submit an Ethereum transaction, which requires paying Ether to miners. And these transactions often get very competitive, which results in a very high gas price and therefore paying even more Ether. We see people pay $100 plus get a single transaction mined. And that makes sense because there's an opportunity to get maybe $100,000 in liquidation bonus on the other side. Now, what we see is that some of these liquidators will use, as I mentioned, these gas tokens, which are basically subsidized gas that gets mined when, and sort of saved when gas prices are cheap and then redeemed

when gas prices are expensive. So you can sort of bank low gas prices earlier on Um, and then when, you know, the, the blockchain starts to get congested, um, or when there's more competition to get mined, you can sort of deploy this reserve of gas that you have, um, and basically outcompete everyone else because you're basically paying below market rate for, for whatever the, the going, uh, going gas rate is. So people get very, very sophisticated with, um, you know, the strategy that, that they employ to run these liquidations. And I think as a result, it's, um, growing increasingly difficult for, um, a retail liquidator to actually, uh, make meaningful profit in this ecosystem. Wow, I've never heard of these gas tokens. How do you create those? It's sort of a weird niche in the, or a weird artifact of how the EVM is designed

such that you can get a rebate for self-destructing a contract that you deploy earlier. So I include a link to, I believe it's gastokens.io is the website for this open source project. But basically you deploy a contract that saves some sort of space, and you get a rebate when you destroy that contract and free up that space in the EVM. And so people will do this when gas prices are super low, basically just deploy a chunk of storage on Ethereum, and then remove it at a later date such that they were able to get back this gas and use it for whatever sort of other transactions that they want, such as running a liquidation.

Wow. That's really smart. So, you know, earlier you kind of were talking about the different ways that there's pressure on these liquidators and also how now the borrowers themselves are getting savvier. So, you know, do you feel like this is kind of a trend that was just at a sort of a moment in time, but as time goes on, we're going to see this kind of go away or, you know, where do you think these people will go eventually? Well, I think liquidations are always to be a part of DeFi as long as over collateralized loans remain a part of DeFi. I think the only thing that changes is the market for this thing and what the margins actually look like for the

people running it. I think right now, or historically, we've been in sort of a high margin, low volume ecosystem, but we're moving to more of a high volume, low margin ecosystem. So I think the things that got us to where we are are probably not going to be the things that get us to an ecosystem where hundreds of millions or billions of dollars of loans are being issued every single day, it's just not going to be necessary to have this sort of large fixed fee in order to keep the ecosystem solvent. That's really the point of having this liquidation penalty is these liquidators are taking on additional cost, additional burden, and need to be properly incentivized to actually repay these loans and make sure the system remains whole. I think we've seen that this mechanism worked extremely well I think Alex Evans from Placeholder did

an analysis and showed that the median liquidation collateralization ratio for maker CDPs was 149%, just 1% below their 150% target. So these things are extremely good at making sure that systems design or function as designed. And now there's just a question of how can we eke more efficiency out of these protocols such that we can get more people onboarded and then there isn't this sort of harsh penalty that is imposed across the entire platform. All right. Well, it's super interesting to see what's going on here. All right. Well, it's been great having you on Unconfirmed. Thanks for coming on the show. Yeah. Thanks for having me, Laura. Don't forget, next up is the news recap. Stick around for This Week in

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Thanks for tuning in to this week's news recap. First up, 2019, the year Ethereum grew more confident. The 2019 version of the annual monster post, Year in Ethereum, is out. Authors Josh Stark and Evan Van Ness call 2019, quote, the year Ethereum grew more confident. The piece showcases the increasing diversity of the DeFi space with significant funds in DeFi being locked in a number of different protocols, ranging from single collateral and multi-collateral DAI to compound, Uniswap, DYDX, Instadap, Synthetix, et cetera. Many of these, by the way, have been featured on Unchained or Unconfirmed. Some of the more interesting numbers in here include the fact that Uniswap liquidity

providers earned more than $1.2 million in fees which was greater than the transaction fees paid in 2019 on Ethereum Classic, Litecoin, and Ripple combined. They also call it a trend that they describe as, quote, financial applications that look like games and games that look like finance. As one example, they name Pool Together the subject of last week's unconfirmed. But another one I would include was this week's launch of set social trading on token sets, which is a place where traders can publicly create and manage their own sets and others can follow these trading strategies simply by minting a token that copies their trades. By the way, I'm not recommending anybody do this. In fact, just reading about it set off all kinds of

alarm bells inside of me. But anyway, this is an example of financial applications that look like games and vice versa. And as for the 2019 year in Ethereum report, there's a lot more in there. So definitely check the full post out. Second headline, Square Crypto announces lightning development test kit. Square crypto reveals a bit of what it's working on a lightning development kit or LDK that quote gives wallet and application developers a convenient way to create custom experiences. They hope it will make it easier to add lightning capabilities to existing Bitcoin wallets and support multi-device, multi-application access to a single wallet. They decided on developing this LDK because they were looking to have an outsized impact on Bic impact on Bitcoin, particularly

non-custodial Bitcoin, and to meet an underfunded need of the ecosystem that doesn't have a clear business model. Meanwhile, Square, the funder of Square Crypto, won a patent for seamless crypto to fiat transactions. Next headline, Bitcoin Cash Miners Create Infrastructure Funding Plan, Setting Off Controversy. While a number of blockchain protocols such as Decred do set aside a portion of the block reward for a treasury to fund further development of the protocol, a recent plan proposed by a Bitcoin Cash miner raised eyebrows for how they plan to go about it. Jiang Zheor, CEO of BTC Top, I'm sorry if I mispronounce your name, wrote a Medium post on behalf

of a group of miners representing a majority of the Bitcoin Cash hash rate. They intend to allocate 12.5% of the Bitcoin Cash Coinbase rewards to a fund to support Bitcoin Cash infrastructure for six months. However, he raised eyebrows when he also stated that the miners would orphan BCH blocks that do not follow this plan. They intend to initiate this on May 15th, 2020. We will see what happens. Next headline. Yet another Libra Association defection. Vodafone. Well, an eighth company leaves the Libra Association. This time it's Vodafone. CoinDesk reports, quote, Libra intends to admit new members to the association in 2020, a person familiar with

the situation said. The waitlist is currently north of 1,500 companies. A roughly two-thirds majority of existing members must agree to add any new participant. Next story, DigixDAO votes to dissolve. Will distributes $64 million in Ether to token holders. One of the earliest token projects to have an ICO, DigixDAO, has voted to dissolve. The token holders voted to liquidate the ETH in the DigixDAO treasury worth about $64 million. The block reports, quote, DigixDAO raised over 460,000 Ether in 2016 via an ICO. In total, the amount of Ether was worth about 5.5 million at the time. However, its value has since gone up significantly.

DGD token, on the other hand, was trading at a 60% discount to DigixDAO treasury balance last month. Thus, DigixDAO gave DGD token holders an option to completely dissolve its treasury. Hilariously, of course, now the value of the DGD token has gone up. So the market cap is now almost three times what it was a month ago. Okay, fun bits. The importance of digital bearer assets. Nick Grossman of USV wrote a short and sweet post about how crypto or Web3 applications enable a new user experience. He says, quote, by bearer assets, I mean that you just show up with them and they are respected sight unseen by whatever applications are expecting them.

For example, a device that has Helium data credits loaded on it can present itself anywhere on the Helium network and it will start working. No user account, no credit card, no contract. Just show up holding the token and it will just work. I like how he describes it here. And in case you're looking for a way to explain what this is all about to newbies, I think that this is something that could be pretty easily grasped. All right. Well, thanks for tuning in to learn more about Tom and his post on liquidations on D5. Be sure to check out the links in the show notes of your podcast player. If you enjoy these news recaps, then why not sign up for the real deal? The weekly newsletter put out by moi every Friday. Some of you have asked me for the links to the stories

I mentioned on the show, and now you can get them delivered right to your inbox. Go to unchainedpodcast.com right now to sign up. Unconfirmed is produced by me, Laura Shin, with help from Factual Recording, Anthony Yoon, Daniel Nuss, Josh Durham, and the team at CLK Transcription. Thanks for listening.