Liquidation via Stablecoin Swaps vs. Liquidation via Volatile Asset Swaps

Minimal Slippage & Predictable Value: Swaps occur within a single price-stable asset class, avoiding the double volatility exposure of selling collateral into a volatile asset. This preserves more value from the collateral for repaying the debt and returning surplus to the user. This matters for protocols with tight health factor margins (e.g., Aave, Compound) where maximizing recovery is critical.

Depeg Contagion Vulnerability: In a market-wide stress event (e.g., USDC depeg in March 2023), liquidations can fail or incur massive losses as the stablecoin's value diverges from its peg. This creates a single point of failure and can cascade across multiple protocols. This matters for risk managers designing for black swan events.

Access to Primary Pools: Direct swaps into major volatile assets (ETH/WBTC) tap into the deepest liquidity pools on DEXs like Uniswap and Curve. This enables larger liquidation volumes to be absorbed with less price impact, crucial for liquidating large, underwater positions quickly without destabilizing the market.

Exposure to Two Volatile Assets: Keepers must manage the risk of the collateral asset and the received volatile asset dropping in value before they can hedge or sell. This requires more sophisticated treasury management and increases operational overhead. This matters for keeper profitability and can lead to insufficient liquidation incentives during high volatility.

Price stability during execution: Swapping collateral for USDC, DAI, or USDT minimizes slippage and price impact during the liquidation event. This is critical for large positions where a volatile asset swap could move the market, worsening the bad debt. Protocols like Aave and Compound V3 benefit from this predictability.

Opportunistic arbitrage: Swapping collateral directly for ETH or other volatile assets allows keepers to capture larger spreads if they believe the asset will appreciate. This can lead to profits exceeding standard liquidation bonuses, attracting sophisticated actors with tools like MEV-Boost relays.

Direct peg exposure: Liquidators receive stablecoins (USDC, DAI) directly, avoiding secondary market risk. This matters for protocols like Aave and Compound, where liquidators can immediately redeploy capital or exit to fiat without slippage.

Simplified risk modeling: Using a single, stable asset as the liquidation output simplifies oracle requirements and reduces the attack surface for price manipulation. This is critical for protocols like MakerDAO's PSM and is a primary reason for its widespread adoption in DeFi 1.0.

Requires deep stable pools: Success depends on massive, concentrated liquidity in pools like Curve 3pool or Uniswap V3 USDC/DAI. During market-wide deleveraging (e.g., March 2020), these pools can experience temporary insolvency or extreme slippage, stalling liquidations.

Lower incentive ceiling: Profits are typically capped at a fixed bonus (e.g., 5-10%). In highly volatile markets, this may be insufficient to attract enough keeper bots compared to the asymmetric upside potential of receiving a volatile asset, leading to liquidation inefficiency.

Asymmetric upside: Liquidators receive the collateral asset (e.g., ETH, WBTC) at a discount. If the asset price rebounds, profits can far exceed a fixed bonus. This matters for protocols like Euler Finance and Solend, which use this model to ensure robust keeper participation during crashes.

Taps into deeper liquidity: Leverages the massive, native liquidity of major assets on DEXs like Uniswap and Balancer. This can be more resilient than niche stablecoin pools during systemic stress, as seen in protocols adopting Flash Loan-enabled liquidations.

Liquidators bear market risk: The receiving keeper assumes the volatility of the collateral asset post-liquidation. This requires sophisticated hedging strategies using perpetual futures (GMX, dYdX) or options, adding operational complexity and cost.

Amplified oracle sensitivity: The health of the entire system depends on the accuracy of two volatile price feeds (collateral and debt asset). This doubles the attack surface for oracle manipulation compared to stablecoin-only systems, a key consideration for new L1/L2 deployments.