The decentralized lending sector has reached a new high, with crypto-collateralized loans categorized as “high-risk” rising to $55 million. This marks the highest level in over two years.
This increase in high-risk loans sparks concerns of a potential spike in liquidation and looming market volatility. Analysts warn that increased liquidation could negatively impact prices, leading to bad debts that eventually cause lenders to lose money.
The Risk of Liquidation Cascades
According to data from IntoTheBlock, loans within 5% of their liquidation price are at their highest level since June 2022, raising concerns about a potential market disruption.
A key indicator to watch in lending protocols is high-risk loans. Here’s why this matters👇
High-risk loans are loans within 5% of liquidation. Spikes in high-risk loans can contribute to:
Cascading Liquidations: Large liquidations can impact the collateral value, putting more… pic.twitter.com/YV1YAGwDrG
— IntoTheBlock (@intotheblock) October 16, 2024
Crypto loans become high-risk when they approach liquidation thresholds. In decentralized lending, traders borrow by locking up crypto assets as collateral.
If the value of that collateral drops by a small margin (5% in this case), the loan becomes undercollateralized, triggering an automatic liquidation.
This increase in high-risk loans could indicate that a market downturn may be near. If collateral value falls even slightly, loans could be forcibly liquidated. This often leads to cascading liquidations that can drive prices down rapidly, affecting the wider market.
The concept of a liquidation cascade is important in decentralized finance (DeFi). When loans are automatically liquidated because collateral values dip too low, a chain reaction can trigger.
As more collateral is sold off to cover loans, prices drop further. This, in turn, leads to more liquidations. The result is a downward spiral with significant market volatility.
According to IntoTheBlock’s report, large liquidations can reduce collateral values even more, putting additional loans at risk. This snowball effect could lead to what the firm described as “a downward price spiral.”
A rapid decline in market prices can outpace the ability of protocols to liquidate collateral, leading to bad debt.
Impact on Market Liquidity and Lenders
In its latest market update, IntoTheBlock highlighted that bad debt could freeze market liquidity.
Bad debts create another layer of risk since the borrowers can no longer meet repayment terms. When loans go bad, market liquidity is reduced, making it harder for traders to execute large transactions at stable prices.
Lenders become hesitant to add new liquidity, fearing potential losses. This reluctance limits the amount of capital available in the market, worsening the liquidity crunch.
The market becomes less flexible when lenders are cautious about adding funds to the system. That makes trading riskier, particularly for larger orders, and increases the chances of price slippage.
Macro Outlook as High-Risk Crypto Loans Surge
The recent surge in high-risk crypto loans reflects a growing unease in the market. When loan liquidations loom, it often signals heightened uncertainty and triggers a wave of defensive actions by traders and investors.
As the $55 million in high-risk loans reaches its liquidation threshold, market sentiment shifts toward fear. According to the market analytics site Macro Micro, the fear and greed index is 66.00 (FEAR).
As such, traders aware of the potential liquidation cascades may react preemptively by selling their assets to avoid losses. This behavior creates a ripple effect across the broader cryptocurrency market, pushing prices down and increasing volatility.
The fear of large-scale liquidations amplifies uncertainty, driving more conservative strategies, such as exiting leveraged positions or reducing exposure to riskier assets.
While logical for individual traders, this cautious approach can result in mass sell-offs, further deepening price declines. Moreover, this negative sentiment extends beyond traders.
Institutional investors and liquidity providers also tend to pull back in such uncertain conditions, reducing liquidity in the market. As a result, the broader crypto ecosystem faces tighter liquidity conditions, exacerbating volatility and making it harder for the market to stabilize.