Delays in Liquidations on Aave and Spark Highlight Growing Concerns Over ETH LST and LRT Liquidity

The decentralized finance (DeFi) world is changing quickly, and platforms like Aave and Spark are becoming crucial for users who want to borrow and lend assets, putting up various kinds of collateral.

But in the week gone by, some users have noticed that when it comes time for the platform to carry out a liquidation order, there’s a delay.

IntoTheBlock data suggests that’s because certain Ethereum-based liquid staking tokens (LSTs) and liquid redemption tokens (LRTs) just don’t have the kind of # liquidity you need to make a DEX work well.

Executing these liquidations has become increasingly difficult. We touched on it above, but it merits a more thorough explanation. Liquidations happen when a borrower defaults—that is, they no longer can or will maintain the required collateralization level (in this case, Ethereum) because its value has plummeted. Yet, the liquidators cannot do their jobs quickly or safely these days because of low liquidity—especially for certain token pairs. Low liquidity means it is hard to find buyers. It also means the buyers who are around might not be willing to buy at prices that the liquidators had thought were reasonable when they started the job. These troubles add time to the liquidation equation, and they increase risks for the liquidators. They might face some potential for loss that they hadn’t anticipated and that we think is pretty significant.

Liquidity Issues Impacting Liquidations

The problem of liquidity in decentralized markets is not new. In classical markets, liquidations happen faster and more efficiently, owing to the high liquidity of most major assets. Yet in the world of DeFi, where liquidity is spread out across a multitude of pools and exchanges, it can vary significantly even between assets that we might assume should have similar levels of liquidity.

When using Ethereum-based collateral, especially in the form of liquid staking derivatives (LSTs) or liquid redemption tokens (LRTs), we are seeing a troubling trend. The level of liquidity on decentralized exchanges (DEXs) for these LSTs and LRTs is actually quite low. LSTs like stETH are now being used as collateral on platforms like Aave to borrow other assets—like Wrapped Bitcoin, for example. But the deeper, darker issue is this: how are we supposed to service that debt (if you’re the LST-wielder) or maintain the health of the lending platform (nobody wants to see a platform go under) if Aave serves as a runway of sorts, and we then have to find a DEX that will accept stETH and staked Bitcoin, or whatever, as viable trading pairs?

Because some DEXs have liquidity that is too thin, liquidators can’t execute timely sales of collateral, and these two factors make for a poor user experience in DeFi lending. If a user borrows assets in a DeFi protocol and their collateral begins to approach the liquidation threshold, on the side of the user experience, there should be an assurance that a timely liquidation will happen under normal market conditions.

A sluggish liquidation process could harm the DeFi platform and the wider market. If a liquidation doesn’t happen fast enough, the collateral stays on the platform, which could mean that it’s about to suffer further drops in value. And what if the platform isn’t about to suffer drops in value, but its owners are just having a terrible time of it because they’re not good at running a business? That’s going to be uncertain for lenders counting on liquidation as a “get out of jail free” card.

ETH/BTC Price Ratio: A Key Indicator of Market Stress

For users of collateral on the Ethereum blockchain, and especially those borrowing tokens like Wrapped Bitcoin (WBTC), it is of utmost importance to keep a close watch on the price ratio of ETH to BTC. Over the past week, this ratio has emerged as a “red flag indicator for acute market stress”— and for a good reason. The DeFi platforms that we have emerged into as users all require Ethereum-based collateral, and in the past week, a huge metric ton of it has been moved across these platforms. Whenever WBTC or other tokens collateralized in ETH are used as backup by these profit-challenged DeFi platforms, any movement (up or down) in the price of Ethereum or Bitcoin is going to recalibrate the ETH/BTC ratio and potentially trigger liquidation events across these same platforms.

If the ETH/BTC pricing ratio tumbles, it might suggest that the collateral value is in danger, um, pushing the whole thing toward a potential cascade of liquidations. Conversely, if the ratio zips upward, it might imply that we’re in a gapped-tightening market, and that increasing demand for liquidations exists to “secure profits.” In both instances, the crucial factor determining how well (or poorly) the liquidation process is managed is the liquidity of the tokens in question.

If you have WBTC or other assets with ETH-based collateral, understanding the price chart of ETH/BTC is crucial for grasping the potential risks involved. Liquidators will be watching these ratios very closely because they directly impact the profitability and timing of liquidation events. In a lower liquidity environment, the price ratio could signal either a business opportunity for quick liquidation or an uptick in risk for delayed liquidation. Either way, we’re definitely not out of the woods.

The Future of Liquidation Processes in DeFi

With the advancement of decentralized finance, it is ever more paramount for DeFi platforms to tackle the problem of liquidity, especially when it concerns assets such as the Ethereum-based liquid staking token. The delays in the liquidations that have recently been experienced on platforms like Aave and Spark call attention to a gathering need for much more serious and solid liquidity solutions, especially for the pairs of tokens that are being—heavily, as it turns out—used as collateral.

To enhance liquidity in decentralized markets, one promising approach might be to encourage deeper liquidity pools for LSTs and LRTs. This would permit liquidators to act more swiftly and efficiently. Another possible approach might be to integrate new liquidity providers into the system. A still further possibility could involve developing more sophisticated algorithms that would help liquidators identify profitable opportunities even in low-liquidity conditions.

Moreover, students taking out loans against their Ethereum-based collateral should start paying attention to the ETH/BTC price ratio, which could become an increasingly vital metric in the context of liquidation events for “DeFi” protocols like Compound and Aave. If the liquidity situation doesn’t improve, student borrowers may need to implement one or both of the following two strategies: a) lessen the exposure to the collateral; or b) keep a closer watch on price movements in the broader market.

Decentralized finance (DeFi) users may find the slow pace of liquidation somewhat irritating. But slow liquidation offers time for reflection—on the DeFi platform’s very structure and what happens to liquidity when it’s needed most. In the wake of the recent solana (SOL) price plunge, some are asking: How resilient are DeFi platforms, and how efficient is their ecosystem for borrowers, lenders, and liquidators?

Disclosure: This is not trading or investment advice. Always do your research before buying any cryptocurrency or investing in any services.

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