Liquidation

What Is Liquidation?

Liquidation is the process by which a lending protocol forcibly sells a borrower's collateral to repay an outstanding loan when the position becomes undercollateralized. It is the primary mechanism that protects lenders from losses and maintains the solvency of decentralized lending markets. In DeFi, liquidation is automated, permissionless, and executed by third-party participants called liquidators who are economically incentivized to act quickly.

Liquidation is one of the most important concepts for anyone borrowing in crypto to understand. It determines the maximum risk a borrower can take and sets the boundaries within which all leveraged positions must operate.

How Liquidation Is Triggered

Every lending protocol assigns each collateral asset a liquidation threshold -- the maximum loan-to-value ratio a position can reach before it becomes eligible for liquidation. For example, if ETH has a liquidation threshold of 82.5%, a borrower whose debt reaches 82.5% of their collateral value is exposed to liquidation.

A position can breach its liquidation threshold in two ways:

Collateral price decline: If the market price of the collateral asset drops, the LTV ratio increases even though the debt amount stays the same. A 20% drop in ETH price can push a position that was comfortably at 65% LTV past the 82.5% threshold.

Accrued interest: Over time, variable interest rates add to the outstanding debt. Even without any price movement, a position's LTV gradually creeps upward as interest compounds. This is a slower risk but still meaningful for positions held over extended periods.

The Liquidation Process

Who Are Liquidators?

Liquidators are independent actors -- typically automated bots -- that monitor blockchain state for positions eligible for liquidation. When they identify one, they submit a transaction that repays a portion of the borrower's debt using their own funds. In return, the protocol transfers an equivalent amount of the borrower's collateral to the liquidator, plus a bonus (typically 5-10%) as profit incentive.

This arrangement creates a competitive market for liquidations. Multiple liquidators monitor the same positions, and the fastest to submit a valid transaction claims the liquidation bonus. This competition ensures that risky positions are closed rapidly, usually within seconds of becoming eligible.

Partial vs. Full Liquidation

Most DeFi protocols use partial liquidation, where only a portion of the debt (often up to 50%) is repaid in a single liquidation event. This approach returns the position to a healthy state while preserving the borrower's remaining collateral. The borrower still has a position after the liquidation, just a smaller one with a better health factor.

Some protocols or extreme market conditions may trigger full liquidation, where the entire position is closed. This typically occurs when the position has deteriorated so far that partial liquidation would be insufficient to restore solvency.

What Happens to the Borrower

After a liquidation, the borrower's collateral is reduced by the amount claimed by the liquidator (debt repaid plus the bonus). The borrower retains the borrowed assets -- those are already in their wallet or deployed elsewhere. The net effect is a loss equal to the liquidation penalty, which is the premium the liquidator receives on top of the debt amount.

For example, if a borrower is liquidated on $5,000 of debt with a 5% penalty, they lose $5,250 worth of collateral (the $5,000 debt plus $250 bonus). The remaining collateral stays in the protocol, and any excess beyond the total debt is still the borrower's.

The Health Factor

The health factor is the primary metric borrowers should monitor to assess liquidation risk. It represents the ratio of adjusted collateral value to outstanding debt. A health factor above 1 means the position is solvent; below 1 triggers liquidation eligibility.

Most protocol interfaces display the health factor prominently, and many offer alerts when it drops below user-defined thresholds. Maintaining a health factor well above 1 -- commonly 1.5 or higher -- provides a buffer against sudden market movements.

Avoiding Liquidation

Borrowers have several strategies to reduce liquidation risk:

Maintain a conservative LTV: Borrowing well below the maximum allowed ratio provides a larger cushion against price drops. Borrowing at 50% LTV when the liquidation threshold is 82.5% means collateral can lose roughly 40% of its value before liquidation becomes a concern.

Add more collateral: If market conditions deteriorate, depositing additional collateral immediately improves the health factor and pushes the liquidation price further away.

Repay part of the debt: Reducing the outstanding loan directly improves the LTV ratio, which may be faster than transferring additional collateral.

Choose less volatile collateral: Stablecoins and blue-chip assets like BTC and ETH experience smaller price swings than small-cap tokens, reducing the probability of sudden liquidation.

Liquidation Cascades

One of the most dangerous dynamics in DeFi markets is the liquidation cascade. When a significant market downturn triggers liquidations, the collateral sold by liquidators enters the open market, further depressing prices. This triggers additional liquidations, which cause more selling, creating a self-reinforcing downward spiral.

Liquidation cascades were responsible for some of the largest single-day losses in DeFi history, including events during the May 2021 crash and the Terra/LUNA collapse in 2022. Understanding this systemic risk is essential for anyone using leverage in crypto markets.

Liquidation Across Protocols

Different lending protocols implement liquidation with varying parameters. Liquidation thresholds, bonus sizes, and the percentage of debt that can be liquidated in a single transaction all vary by protocol and by asset. Borrowers using multiple protocols should understand each one's specific mechanics, as a position that feels safe on one protocol might be closer to liquidation risk on another with tighter parameters.