Solving the protocol risks during sell-cascade event

Last updated on Mar 3, 2023

Sell-cascades & smart contract exploits are two of the biggest risks concerning the defi ecosystem today. While the SOPs for smart contract security has evolved over the last few years, reliable solutions to secure the defi lending services against sell-cascade events are still at a nascent stage.

Understanding the sell-cascade event

Sell-cascade is an event during which the majority of the cryptocurrency market displays bearish volatility in double-digit percentages within a few minutes to a few hours. The most visible example is from March 13, 2020. On this day, both the cryptocurrency and traditional equity markets collapsed to levels not seen since the peak bear market of late 2018. While today, the average volatility is comparatively better than pre-2018 time. it remains a critical concern for decentralised financial lending projects, as a constant threat.

For perspective, MakerDao suffered a loss of $4.5million in ETH during the March 13 crypto-crash. While the sell-cascades are an edge, once a year type scenarios, the probability of it playing out is 100%. Thus, systemic redressal of this bottleneck becomes a must solve the requirement for every defi lending project.

DeFi lending solutions, & the role of Liquidators

Most defi lending products rely on middlemen known as liquidators to liquidate distressed loans, i.e. when a loan reaches its liquidation price, the liquidators are the ones who undertake the responsibility of liquidating such loans, and repay the loan to the protocol. In exchange, to incentivise the liquidators, distressed loans are discounted between 5–15% depending on the protocol. While the presence of liquidators improves a protocol’s overall transparency, ergo credibility, it comes at a cost of significant risks during sell-cascade events, specifically when the price drops are steep with little to no reaction time for the liquidators.

Liquidators & Congested networks

During the sell cascade, as many cryptocurrency projects suffer significant value loss in dollar value, this adversely increases the probability of a healthy loan turning distressed; creating systemic instability. While many liquidators use bots to snipe liquidations, congested networks play the role of spoilsport delaying liquidations. This further creates a cascading effect through queued liquidations, evolving into a single point of failure. Unfortunately, no protocol in the market today be it Compound, Aave, MakerDao, or even the likes of Solend, Benqi are prepared to address such a critical edge but certainly possible case.

At Hashstack, while we are proponents of FOSS; we also are pragmatic in our understanding that the need to be transparent should not undermine the product’s security. A secure product at the end of the day is a reliable product. and a reliable product has better longevity. Further, there are many ways transparency can be implemented.

Protocol risk amplifier — Listing illiquid coins

While a sell cascade creates volatility even for the high liquid coins such as Bitcoin, USDT, USDC, It does not bode well for mid & low cap coins. Deposits/Loans must be facilitated only in the coin denominations with visible data of consistent supply-demand. Efforts must be made to avoid listing illiquid coins, even as a community service.

Illiquid coins suffer the most value-loss during a sell cascade.
They are difficult to liquidate.
The demand for illiquid coins is seasonal.

What is the probability of a borrower’s preference to secure a loan, or to deposit assets in price-stable & liquid coins such as USDT, BTC, in comparison to BAT?

Band-aid fix

In response to the market crash of March 13, Compound protocol increased the liquidation discounts from 5% to 8%, in addition to a few cosmetic changes. Aave’s reaction was also in line with Compound. The increase of discount percentage provides an additional cushion, it does not address the elephant in the room.

Open’s solution

With Open we have addressed the problem of sell-cascade risks at the protocol level. Before we dive into the solution, let us quickly narrow down the cause & effects a market crash has over the current defi lending products.

Illiquid markets suffer the most value-loss against liquid markets.
Total reliability on liquidators creates a single point of failure.
Network congestion creates a liquidation-cascades, ergo high-slippages.

One of the novel mechanisms implemented within Open is that of the concept of compartmentalisation of almost every critical component, to ensure better predictability of liquidity as well as stability. Compartmentalised deposits & loans while incentivising the users against minimum deposit/loan commitment periods, compartmentalisation of markets supported enables the protocol to support a wider number of markets, while also restricting itself to a handful of super liquid markets.

Explaining further, at Open, the markets supported are categorised as,

1. Primary markets — BTC, USDT, USDC, BNB

2. Secondary markets — CAKE, SXP + 12 more.

The process of deposits & loans is denominated in the primary markets only. This handful list of coins is adopted as the base coins across major cryptocurrency exchanges. So naturally, there is a consistent supply-demand for these markets. Further, these markets have a good probability of a direct trading pair with all the other major cryptocurrencies.

By supporting only high liquid markets, Open improves the odds of successfully liquidating a distressed loan with minimal slippages, in the event of a sell cascade. But, who is to say that these markets will not suffer double-digit percentage drops in a shorter period? After all, bitcoin itself lost 43% value since December, with 10+% value-loss on multiple days.

During such occurrences, timely liquidating distressed loans become a critical requirement. However, the total reliability of liquidators in conjunction with congested networks induce unpredictability and create systemic risks. This is a much bigger problem than supporting illiquid coins.

We are solving this problem through the implementation of a fail-safe liquidation mechanism. In this solution,

Liquidations are processed by liquidators[default], and protocol[fail-safe, automated].
Chain-switch oracle to navigate through network congestion issues.

Considering the high costs associated, every defi lending solution monitors active loans & deposits on their servers, while contextually updating the on-chain storage variables. When a loan drops to its liquidation price, it is displayed in the dapp through an API response for liquidators to liquidate and repay the protocol on behalf of the borrower. At Open, we have implemented a second checkpoint for distressed loans to ensure that they are liquidated. This involves monitoring a distressed loan after it is displayed in the liquidation-ready loans part of the web application. If a distressed loan remains yet to be liquidated while the collateral-discount loses 25% USD value, the protocol assumes the role of a liquidator, & automatically liquidates the distressed loans. The open protocol is built and deployed for Binance smart chain considering the network reliability and ease of development.

With Open protocol, a fraction of the reserves is converted into their wrapped versions and deployed through fractional reserve lending across high through-put L1 networks such as Avax-c-chain, Harmony. This allows Open protocol to navigate through network congestion issues, by chain-switch oracle. During the instances where-in BSC network is congested, the liquidation of the distressed loan can be processed on another L1 such as Harmony, which may have fewer constraints on the network. A combination of a fail-safe liquidator, chain-switch oracle and automated asset rebalancing while technically complex to implement, ensures a high probability of protocol security during the sell-cascade events.

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