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Lending protocols are a critical part of the DeFi ecosystem and liquidations ensure these protocols are operating properly. However, there are instances when liquidating a single large entity's position causes systematic risk to the whole ecosystem.
Liquidating assets in most lending platforms depends on keepers buying undercollateralized assets and selling them on different venues. When the liquidation is larger, more complex systems like dutch auctions are used to sell the undercollateralized assets in batches to keepers.
There are instances when even dutch auctions have trouble handling the size of the liquidations. One reason why dutch auctions are popular is that there's no resting liquidity needed. However, there are drawbacks like a limited set of participants, discrete price discovery, and most importantly development overhead to set up the auction.
Liquidating dramatically causes the price of the collateral to drop suddenly and this is an issue especially when it's the core asset of the blockchain i.e ETH, SOL. The cascading effects of the severe price drop can cause other DeFi protocols to start failing as well, thus bringing about a potential ecosystem-wide disaster and loss of capital.
This could have potentially happened on Solana because of the lack of maturity of the liquidation services and liquidity on-chain to digest such a large liquidation. The protocol even considered forcefully taking custody of the whale's assets (!!) to sell them gradually on OTC desks.
TWAMMs can liquidate these large positions gradually over multiple blocks, thus giving the asset price time to recover. Unlike dutch auctions, there needs to be resting liquidity to process these sales. However, this isn't an issue for the primary collateral used on lending platforms, the blockchain's base asset.
Additionally, TWAMMs are extremely programmable and flexible with minimal overhead. Instead of relying on a select group of keepers being online or having the capital to execute such large liquidations, TWAMMs open up access to everyone and offload the price discovery of sales on arbitrageurs.
Beyond processing large liquidations, TWAMMs can also help liquidate other positions in a more profitable manner. The pre-dominant on-chain strategy used today is buying the under-collateralized asset and dumping it on a DEX in a single block thus not taking on collateral price risk.
Most of the profits are realized by MEV bots that back-run these trades. However, liquidations can be a lot more profitable if the assets were TWAP sold gradually, but this comes with collateral risk. One solution to address that is described below where Smaller participants increase their leverage by coordinating their capital and buying more underpriced collateral to liquidate all while hedging downside risk.