What is Liquidation?
In DeFi lending, liquidation is the process of selling a borrower’s collateral when the value of their loan position drops below the required threshold. This protects the protocol from becoming insolvent when borrowers can’t repay their loans.
Unlike traditional finance where a bank forecloses on your house, DeFi liquidation is fully automated — smart contracts monitor positions 24/7 and anyone can trigger a liquidation to earn a reward.
Liquidations are essential to the health of lending protocols like Aave, Compound, and MakerDAO. Without them, a market crash could leave protocols with bad debt — unable to repay depositors.
How Liquidation Works
The Health Factor
Every borrowing position has a health factor — a number that represents how safe the position is:
Health Factor = (Collateral Value × Liquidation Threshold) / Total Borrowed Value| Health Factor | Status | What Happens |
|---|---|---|
| > 2.0 | Very safe | Large price buffer before liquidation |
| 1.2 - 2.0 | Safe | Normal operation |
| 1.0 - 1.2 | At risk | Price drop could trigger liquidation |
| < 1.0 | LIQUIDATABLE | Position can be liquidated by anyone |
When the health factor drops below 1.0, the position becomes eligible for liquidation.
The Liquidation Process
- Monitoring: Keeper bots (automated scripts) constantly scan for positions with health factor < 1.0
- Liquidation trigger: A keeper calls the protocol’s liquidation function, repaying part of the borrower’s debt
- Collateral seizure: The protocol transfers collateral to the liquidator, plus a liquidation bonus (typically 5-10%)
- Partial vs full: Most protocols liquidate up to 50% of the position at a time, not the full amount
Example:
- You deposit 10 ETH ($30,000) and borrow $15,000 USDC
- ETH drops 30%, making your collateral worth $21,000
- Liquidation threshold is 80%, so minimum collateral needed: $15,000 × 1.8 = $27,000
- Your $21,000 < $27,000 → position is liquidatable
- A keeper repays your $7,500 debt (50% of position)
- They receive $7,500 + 8% bonus = $8,100 in ETH
- You lose ~$600 extra to the liquidation penalty
Liquidation Thresholds by Asset
Different assets have different risk parameters:
| Asset | Loan-to-Value (LTV) | Liquidation Threshold | Bonus |
|---|---|---|---|
| ETH | 82.5% | 88% | 5% |
| WBTC | 73% | 83% | 5% |
| USDC | 80% | 86% | 4.5% |
| stETH | 72.5% | 79% | 6% |
| Altcoins | 30-50% | 45-65% | 8-10% |
Stablecoins have higher LTVs (lower risk), while volatile altcoins have much lower LTVs and higher liquidation penalties.
The Liquidation Economy
Liquidations have created an entire MEV economy:
Keeper Bots
Specialized bots compete to liquidate positions. The first to execute wins the bonus. This competition has driven the development of:
- Flash loan liquidations: Borrow capital to liquidate, repay from seized collateral
- MEV bundles: Submit liquidations directly to block builders for priority
- Multi-chain keepers: Monitor positions across Ethereum, Arbitrum, Optimism simultaneously
Liquidation Aggregators
Protocols like Instadapp Lite and Defi Saver offer users automated protection:
- Auto-deleverage: Automatically repay part of your debt before liquidation
- Auto-swap: Swap collateral to stablecoins as prices drop
- Notifications: Alert users when health factor drops below a threshold
How to Avoid Liquidation
- Maintain a high health factor (>1.5): Don’t borrow the maximum. Leave a large price buffer.
- Monitor your position: Use apps like DeBank or Zapper to track your health factor in real-time.
- Use stablecoin collateral: Stablecoins don’t drop in value, so liquidations only happen if your borrowed asset pumps.
- Set up alerts: Protocols send notifications when health factor drops.
- Have a repayment plan: Keep some assets liquid to repay debt if needed.
- Avoid borrowing against correlated assets: If you borrow against ETH and ETH drops, both your collateral and borrowed asset may be affected.
Risks During Market Crashes
During extreme volatility (like March 2020 or May 2022):
- Gas prices spike: Liquidations can cost $500+ in gas, making some positions unprofitable to liquidate
- Price cascades: Mass liquidations create selling pressure, driving prices down further
- Bad debt: If collateral value drops faster than liquidators can act, protocols incur bad debt
- Oracle delays: If price feeds lag, positions may be liquidated at stale prices
Frequently Asked Questions
Q: How much do I lose in a liquidation? A: Typically 5-10% of the liquidated portion as a penalty, plus gas costs. If 50% of your position is liquidated with an 8% bonus, you lose ~4% of your total position.
Q: Can I get liquidated if my collateral goes up in value? A: No. Liquidations only happen when collateral value drops relative to borrowed amount. If your collateral appreciates, your health factor improves.
Q: Who profits from liquidations? A: Keeper/liquidator bots earn the liquidation bonus. The protocol benefits by maintaining solvency. The borrower loses the penalty.