A Liquidation Strategy That Profited $1 Million During the Creation of Aave's $1.6 Million Bad Debt.
It seems we may have underestimated liquidators.
Background
Starting on Nov 13, 2022, the CRV shorter deposited 63.596 million USDC on AAVE V2 and borrowed 92 million CRV. They sold about 20.45 million CRV on DEXs, causing the price of CRV to decrease from 0.59 to 0.43 USD. Around 11:00 on Nov 22, 2022, the CRV price began to increase, and the shorter's position triggered the liquidation threshold. A total of 21 liquidators participated in 385 liquidations to liquidate the CRV debt (EigenPhi Research, 2022). In this article, we will take a closer look at the strategies of one of the most profitable liquidators and then provide an analysis of the liquidation process from a liquidator's perspective.
Liquidation Strategy
Liquidation Process
Let's look at the CRV liquidation strategy used by this liquidator. In brief, he liquidated a total of 9 million CRV and profited about $1 M. Most of the profit came from his exposed CRV position being in the same direction as the CRV price change.
We can divide the liquidator's actions into four stages. In the first stage, on November 19, when the CRV price was still relatively low, the user increased his CRV position by 1,911,562 at an average price of 0.44254018441 USD/CRV through DEXes. In the second stage, after the CRV price increased, he used these CRV to liquidate 2 million CRV debts on AAVE, obtaining a total of 1,365,638 USDC as collateral. In other words, he closed his previous CRV position at an average of 0.682819 USDC/CRV. This liquidator earned at least $459,000 in revenue during these two stages.
In the third stage, the liquidator started shorting CRV. His method was to deposit USDC and other tokens to AAVE and borrow CRV. He used this CRV directly to liquidate the CRV shorter's debt and exchanged it for USDC, thus realizing his short position. It is worth noting that this liquidator deposited the exchanged USDC into AAVE to borrow more CRV to start revolving borrowing. With this method, he liquidated 7 million CRV and exchanged 5,190,365 USDC. In other words, the average price of his short CRV positions was 0.74148071428 USDC/CRV. The following day, in the fourth stage, he repaid the CRV’s debt and closed the short position. The average price of his closing position is 0.6537846888797088 USDC/CRV. His successfully executed short strategy during the third and fourth phases profited about $613,000.
In general, this liquidator successfully executed his strategy of longing and then shorting CRV through liquidation to achieve a total expected income of one million USD.
Strategy Analysis
In the graph above, we can see the liquidator has an accurate view of the CRV market move. Besides, he can proficiently change his position by seeking liquidation opportunities in the fluctuation of CRV price to maximize profit.
To further illustrate the underlying reason why this strategy’s profitability stands out, I would like to show an example of the common atomic liquidation in MEV, that is, the CRV-neutral strategy in liquidation. The liquidator usually borrows capital with a flash loan, swapping it for CRV, uses all of CRV for liquidations, gets the collateral, and repays the flash loan. However, the biggest problem with this strategy is that when the market price changes rapidly, that is, when the capital flow on DEXs is consistent and the same as that of the liquidator, the profitable liquidation space will be reduced. However, in the CRV-short liquidation, the revenues and risks brought about by the capital flow in DEXs within the market microstructure can be reduced, and the profits and risks are placed in the price fluctuations of CRV in the longer term. In this example, this strategy reduces the loss from the capital flow on the DEXs and profits through an accurate view of the CRV price change.
Profit Calculation
In our previous report (EigenPhi Research, 2022), we discovered the total revenue of the 21 liquidators was around 3.5 million. We want to clarify the calculation method in the report only calculates the revenue inside the atomic transaction, not necessarily the actual income obtained by the liquidator. For example, our report stated 0xc377 had a liquidation revenue of $358,766. However, the real profit is around $1 million.
Contract Risk from Liquidators' Perspective
In our previous report (EigenPhi Research, 2022), we point out that about 75% of the liquidation only liquidates no more than 1% of the remaining debts, far less than the 50% threshold. Here we want to explain a little bit about why this is happening and how it is related to the $1.6 million bad debt on AAVE.
For protocol designers, if the debt can be restored to a healthy level through liquidation in the shortest possible time, the protocol can reduce the risk of bad debts. Therefore, we can determine liquidators play a significant role in the risk of protocols. In this CRV bad debt event, we can notice that the liquidator is not willing to comply with the design of the protocol and liquidate the debt in time.
Why is that happening? We previously introduced two types of CRV liquidation strategies. A liquidation CRV-neutral and a CRV-short strategy.
For the CRV-neutral liquidation strategy, every time Chainlink updates the CRV price, there is a cap for the maximum liquidation profit amount. With the market capital flow "buying" the CRV in the market (like DEXs), the profitable liquidation amount will decrease. Compared with the amount of debt, the profitable liquidation amount is relatively small.
For the CRV-short liquidation strategy, reducing the CRV longing position or adding to the CRV shorting position is usually in accordance with their position size. Most liquidators may not afford to liquidate a large percentage of the large debt and get a position of the same size as the shorter introduced in this article.
In general, the root cause of the liquidator's noncompliance to the design comes from the enormous debt scale (relatively small market liquidity) and the rapid rise in prices in a short period (the market's capital flow), which brings substantial risks of bad debt for AAVE.
Here we will look closely at how the failure of timely liquidation brings bad debt to AAVE. In short, the overall financial situation of this debt gets worse as the price of CRV rises. Also, the liquidation gets a larger amount of collateral while repaying the same amount of debt as the CRV price increases.
Here is a graph showing the change in CRV price, the liquidation threshold, and the threshold of a toxic spiral on 22 November 2022.
As shown in the graph, when the price exceeds the liquidation threshold, the liquidation mechanism is triggered, and the liquidator can liquidate the debt. At this time, timely liquidation can make debt financially healthier. When prices cross the threshold of a toxic spiral, each liquidation makes the debt financially worse. Therefore, for protocol designers, there is a healthy liquidation time window between the liquidation threshold triggering and the toxic spiral. It is critical to attracting liquidators to liquidate within this window.
Here we are taking a closer look at the contribution of each liquidation to the overall debt as the CRV price changes on November 22. While the CRV price reaches the liquidation threshold, the liquidator only takes a relatively small amount of collateral for repaying a fixed amount of debt. The liquidation at this time makes a "positive" contribution to reducing the possible bad debt. However, as the CRV price increases, the liquidator takes a relatively large amount of collateral for repaying a fixed amount of debt. The liquidation at this time makes a "negative" contribution to generating bad debt.
Specifically, for the liquidator 0xc377, here is the graph of the bad debt factor for each liquidation. Since the liquidators liquidate at a relatively high CRV price, this liquidator contributed an estimated 492793.6 CRV of bad debt based on the model.
Generally speaking, from the lending protocol designers' perspective, timely liquidation before the price goes high is the key to reducing the risk of bad debt. In the case of this CRV liquidation, the CRV-neutral strategy was limited by the capital flow and liquidity on the market. The CRV-short liquidation strategy could not afford or was unwilling to take a larger CRV position change. These reasons caused the liquidator to fail to liquidate the debt promptly, generating the bad debt.
For lending protocol designers, how to attract liquidators or even use their own funds to liquidate in time is a topic worth discussing. But at the same time, building a model to minimize the impact on borrowers is a tradeoff worth considering.
Conclusion
In this article, we took a close look at a liquidation strategy executed by a specific liquidator who has about $1M in revenue.
Here are some main takeaways:
We present a liquidator's strategy that profits about $1M during the massive CRV debt liquidation.
We may have underestimated the actual profit for liquidators in our previous report. The real profit might surpass $3.5M if we consider the liquidator's extra gain from position rebalances.
We answered a question posted in our previous report. Why do the liquidators not comply with the mechanism designed by AAVE and only liquidate a small part of the debt every time? The reasons are large debt amounts, relatively small liquidity, and consistent capital flow.
We look closely at how failure to liquidate debts at relatively low CRV prices generates bad debts.
We showed how liquidation plays a significant role in the risk of bad debt for lending protocols. Specifically, the liquidator 0xc377 had a relatively negative influence on bad debt generation because they liquidated at a relatively high CRV price.
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