A crypto cliffhanger brought back from the brink

While macro degens were watching the Federal Reserve on Wednesday, crypto degens were focused on another drama: a loan backed by roughly $250mn in ether narrowly avoided liquidation by a technical quirk and heaps of luck.

In case you haven’t heard, “crypto winter” is here. Bitcoin is down more than 50 per cent this year, and ether has lost more than 66 per cent. Lender Celsius has frozen customer withdrawals and reportedly hired restructuring lawyers. Coinbase is laying off almost one-fifth of its sizeable workforce. The season may have its own publicity stunts.

One large wallet reached the precipice on Wednesday where liquidation would have triggered an avalanche of selling pressure. Its owner is not known. An early rumor — due to a probable mislabeling by data provider Nansen — was that the wallet belonged to hedge fund Three Arrows Capital (aka 3ac), whose founder had published a vague tweet about “working this out” and is reported to be facing pressure from lenders. But the Nansen label has since been removed from the wallet, and a person with expertise in analysing such things tells us they don’t believe it belongs to 3ac.

If only 3ac, or truly all of us, were this lucky:

Explaining just how close the wallet came to getting blown out is a good exercise because it helps us understand how lending and liquidation work in the world of DeFi.

The account has shored up its loan and paid down some of its debt since its close call. But we can see that the wallet now has $238mn of ether posted as collateral on DeFi protocol/lending platform Aave for a $167mn loan of stablecoins usdc and usdt.

DeFi loans need to be overcollateralised as a general rule, with smaller buffers for safer tokens and larger ones for riskier tokens. If the value of the pledged collateral drops below a certain threshold, the liquidators step in.

Liquidators are bots that troll around DeFi protocols, identify wallets with undercollateralised loans and then liquidate the account by selling the collateral off for profit — Dragonfly Research has a nice explainer of the specifics.

Once a wallet goes into DeFi default, we are told, the liquidators move in fast. But on Wednesday morning, the price of ether fell below the implied liquidation price. At the time that was said to be around $1,015.

So what happened? Why didn’t the account get liquidated?

As the above tweet explains, it was an issue of “oracle update latency”. That issue does not have anything to do with Larry Ellison or microwave towers, however, because this is cryptoland and everything needs to have a dumb name.

At risk of oversimplification, an “oracle” is essentially a data feed that helps smart contracts perform their function. In this case a service called chainlink puts prices on the blockchain so Aave’s smart contracts can use them to operate.

This isn’t the futures market, and updating prices on-chain is expensive. So they aren’t refreshed in real time. Instead, chainlink updates the on-chain prices when the “off-chain” data deviates by 0.5 per cent or more from the latest update, or every hour.

When ether fell to around $1015, it would have triggered a sizable liquidation if it had met the criteria for the price to go on-chain.

But it didn’t. It wasn’t a large enough move compared to the price recorded in the prior on-chain update, and it didn’t last for an hour. So instead of getting blown out of around $250mn in ether, the account got to live another day.

This type of thing happens all the time in TradFi, of course. In fact, it has happened very recently, as our colleagues have reported. Citigroup was late meeting a margin call from Intercontinental Exchange during the market turmoil of March 2020, but the Ice executives decided it was more important to “do no harm” and avoid a “cataclysmic” event.

What makes the Aave incident so notable is that DeFi is built entirely to avoid these situations.

The decision to give Citi grace was made on purpose, by a human, who decided that rule bending was for the greater good of the market and financial system.

There is a certain amount of flexibility in enforcement — and some obfuscation of price discovery — that comes with high-touch human interaction. Your exchange cuts you a break, or your broker just stops answering the phone for a while when markets are looking ugly. Part of the libertarian appeal of DeFi and crypto is that everything is mechanical; smart contracts don’t care about preserving financial stability.

Traders can still catch a break in crypto too, it seems. The whims of the crypto gods are just a lot more arbitrary.

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