How to Reduce Liquidation Risk in Leveraged Yield Farming
Leveraged yield farming can offer higher returns but also comes with greater risk. One of the most significant risks is liquidation.
When you open a leveraged position, the additional capital from your own funds acts as collateral. When the value of the collateral is no longer enough to cover the debt, it is at risk of liquidation and losing a portion or all of the collateral.
Different protocols have different liquidation parameters.
The liquidation ratio on OpenWorld's is 83.33% for most trading pairs (LTV ratio). This means that when the ratio between the debt value (Debt Value) of a trading position and the asset value (Position Value) exceeds 83.33%, the position will be liquidated. This ratio leaves a buffer of approximately 16.67% before the position is subject to liquidation.
Example of Liquidation
Here are some terms to understand before calculating liquidation:
Debt Value: The value of the loan
Position Value: The value of the yield farming position
Debt Ratio = Debt Value / Position Value
Equity Value = Position Value - Debt Value
Suppose the price of Token A is 0.5 USD and the price of Token B is 2 USD.
A user opens a leveraged yield farming position 3x with the Token A-Token B pair.
The user deposits 5,000 Token B (10,000 USD) and borrows 40,000 Token A (20,000 USD).
The user's assets are converted at a 50:50 ratio to create LP tokens. The position now has 30,000 Token A (15,000 USD) and 7,500 Token B (15,000 USD). The total position value is still 30,000 USD.
The current debt ratio of the position is 20,000 USD / 30,000 USD = ~66.67%
After 1 day, with no trading fees and profit reinvestment:
The price of Token A is now 0.6 USD, Token B is 1.5 USD.
The total position is now 23,717.08 Token A and 9,486.83 Token B.
The new debt value is 24,000 USD (40,000 Token A * 0.6 USD).
The total position value is 28,460.5 USD.
The new debt ratio is 84.33%.
Exceeding the liquidation threshold of 83.33%, the position will be liquidated.
The remaining equity value is 4,460.5 USD. After deducting the 5% liquidation fee, the user receives 4,237.475 USD.
Some Ways to Reduce Liquidation Risk
Add more collateral when the loan-to-collateral ratio exceeds a safe threshold.
Choose to farm assets with low volatility such as BTC, ETH, and stablecoins.
Use risk management tools such as stop-loss.
Analyze the factors that affect liquidation risk.
Choose a platform with good risk management mechanisms.
Conclusion
Liquidation occurs when the debt ratio exceeds the allowable threshold. In most cases, the smart contract will close the position, repay the debt, and return the remaining assets. Calculating and predicting liquidation risk is difficult. Therefore, a tight risk management strategy is needed to minimize losses when using leveraged yield farming.