What is Liquidation?
Liquidation is the process by which a DeFi lending protocol forcibly closes a borrower's position when their collateral value falls below required thresholds. It's the mechanism that protects lenders and maintains protocol solvency when borrowers can't or won't manage their debt.
Think of it like a margin call in traditional finance, but automated and instant. When your loan becomes undercollateralized, anyone can repay part of your debt and claim a portion of your collateral at a discount. This discount incentivizes rapid liquidations, keeping protocols healthy.
Understanding liquidation mechanics is essential for anyone borrowing in DeFi. The protocols don't send warnings. Your position can be liquidated 24/7 without notice.
Key Concepts
Loan-to-Value (LTV)
LTV represents how much you can borrow relative to your collateral:
LTV = (Borrowed Amount / Collateral Value) × 100%Example: Deposit $10,000 ETH, borrow $5,000 USDC → 50% LTV
Each asset has a maximum LTV. Higher LTV means more capital efficiency but less safety buffer.
Liquidation Threshold
The point at which your position can be liquidated. It's always higher than maximum LTV to provide a buffer.
| Asset | Max LTV | Liquidation Threshold |
|---|---|---|
| . . . - | . . . . - | . . . . . . . . . . . |
| ETH | 80% | 82.5% |
| WBTC | 75% | 80% |
| Volatile tokens | 50-65% | 60-75% |
Health Factor
A single number representing position safety:
Health Factor = (Collateral × Liquidation Threshold) / Debt- Health Factor > 1: Safe
- Health Factor = 1: At liquidation threshold
- Health Factor < 1: Can be liquidated
Most protocols display health factor prominently. Keep it above 1.5-2.0 for volatile assets.
How Liquidation Works
The Liquidation Process
- Trigger: Your health factor drops below 1 (or protocol-specific threshold)
- Detection: Liquidation bots monitor all positions constantly
- Execution: A liquidator repays part of your debt (typically 50%)
- Seizure: The liquidator receives collateral worth the repaid debt plus a bonus
- Result: Your debt decreases, but so does your collateral
Liquidation Bonus (Penalty)
Liquidators are rewarded with a discount on seized collateral:
| Protocol | Typical Bonus |
|---|---|
| . . . . . | . . . . . . . - |
| Aave | 5-10% |
| Compound | 8% |
| MakerDAO | 13% |
If you're liquidated, you lose this percentage of your collateral beyond the debt repaid.
Partial vs Full Liquidation
Most modern protocols use partial liquidation:
- Only 50% of your debt is repaid per liquidation
- This gives you a chance to add collateral after the first liquidation
- Multiple liquidations can occur if you don't act
Some protocols (like MakerDAO) use full liquidation for certain vaults.
Why Liquidations Happen
Market Volatility
The most common cause. If your collateral (e.g., ETH) drops in price:
- Collateral value decreases
- Debt remains constant
- LTV increases toward liquidation threshold
Accruing Interest
Borrowed amounts grow with interest:
- Interest compounds over time
- Debt increases even if market is stable
- Eventually pushes LTV beyond threshold
Oracle Price Updates
Protocols use price oracles that update periodically:
- Price might gap significantly between updates
- You could go from "safe" to "liquidated" in one update
- Fast-moving markets are especially risky
Avoiding Liquidation
Monitor Your Positions
- Set up alerts for health factor drops
- Check positions at least daily during volatile periods
- Use portfolio trackers like Fensory for real-time monitoring
Maintain Healthy LTV
- Borrow well below maximum LTV
- Target 50% of maximum LTV for volatile collateral
- Leave room for price drops
Use Stablecoins as Collateral
If you're borrowing stablecoins:
- Stablecoin collateral reduces liquidation risk significantly
- ETH as collateral + USDC debt is more risky than USDC as collateral + ETH debt (if you want ETH exposure)
Set Up Automation
- Use DeFi automation platforms (DeFi Saver, Instadapp)
- Configure automatic repayment or collateral addition
- Some platforms offer "Automation" that rebalances your position
Have Reserves Ready
- Keep assets available to add as collateral
- Ensure you can access funds quickly (not locked in long-term staking)
- Consider the total portfolio risk, not just individual positions
Liquidation Strategies for Liquidators
Liquidation is a profitable business. Liquidators:
- Monitor all borrowing positions on-chain
- Detect positions becoming undercollateralized
- Submit liquidation transactions (often via flashbots)
- Compete on speed and gas prices
- Capture the liquidation bonus
This is highly competitive. Professional liquidators use sophisticated MEV strategies and often operate at the block builder level.
Self-Liquidation
Sometimes it's better to liquidate yourself:
- Flash loan to repay your debt
- Receive your full collateral
- Sell collateral to repay flash loan
- Keep remainder (instead of paying liquidation penalty)
This saves the 5-10% liquidation penalty but requires smart contract interaction.
FAQ
What happens to my remaining collateral after liquidation?You keep any collateral not seized. If you had $10,000 collateral and $5,000 debt, and 50% was liquidated, you'd still have roughly $4,700-4,750 collateral remaining (minus the liquidation bonus).
Can I prevent liquidation once it starts?No. Once a liquidation transaction is submitted, you can only hope it fails due to network issues. Prevention must happen before you reach the threshold.
How much do liquidators make?Varies widely. The liquidation bonus is 5-10%, but competition reduces actual profits. Most liquidators operate on thin margins with high volume.
Are all my positions liquidated at once?Usually only part of one position. Protocols typically liquidate 50% at a time, and each collateral type is separate.
Related Topics
Learn about LTV optimization, understand borrowing strategies, and explore automated position management.
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