4. External Liquidators

External liquidators are third-party actors who scan the protocol for insolvent borrow positions, repay the pool the borrower borrowed from, and receive the same value in collateral supplied by the borrower. The process is incentivized by allowing liquidators to purchase positions at a discount to market rates, with the discount acting as their fee. The liquidity required for liquidation events is commonly supplied via flash loans, so liquidators can profit without requiring capital. External liquidators do fulfil an important role for the protocol, as they maintain the solvency of borrower positions, and so the overall solvency of the protocol’s token markets.

The current model as described above is effective but comes at a significant cost to liquidity providers and token holders. External liquidators require the value of liquidation events to be substantial enough to incentivise them to act. As a result, the minimum proportion of borrower collateral sold in liquidation events is almost always higher than that required to return the account to solvency.

The liquidator becomes the sole beneficiary in such cases, given they make a larger fee. The minimum proportion sold is often punishingly high, with 50% being not uncommon. In lending protocols liquidation fees range around 40% of the total all, an amount that measures in the hundreds of millions across the sector.

In such a model the favoured liquidator few feast on the misfortunate liquidity provider many. A select few extract extraordinary value from the protocol but forfeit its benefit to the whole user community.