What happens if crypto drops sharply overnight?
What happens if crypto drops sharply overnight?
A crypto-backed loan has to be built to cope with a fall at 3 a.m., not just during business hours. So the protections are designed to work automatically, without anyone needing to react in real time.
What the drop does
When the collateral falls in value, the loan-to-value (LTV) rises toward the liquidation threshold. The gap between the LTV a borrower starts at and the liquidation threshold is the buffer. A conservative buffer is sized so that a large overnight move can be absorbed without triggering liquidation at all.
If the threshold is crossed
If the LTV does cross the threshold, liquidation runs automatically under the rules set when the position was opened: part of the loan is repaid from the collateral, bringing the position back to safety before the collateral is worth less than the loan. It doesn't wait for anyone to wake up.
Some positions also carry hedges, such as options that gain value as the collateral falls. Where a hedge is in place, it offsets part of the move. Hedges reduce the impact of a fall, but they don't remove it entirely.
What it means for you
No structure makes a severe crash costless. A well-designed one makes sure the response is automatic, sized in advance, and doesn't depend on someone reacting at the worst moment. Before pledging or investing, check the starting LTV, the liquidation threshold, how liquidation works, and whether any hedge is in place and what it covers.
Related: What triggers liquidation of my pledge? and What is hedging?.