Liquidation

A numerical metric representing the safety of a borrowing position, calculated as the ratio of the collateral value to the borrowed value. When the Health Factor drops below 1.0 (or a protocol-specific threshold like 1.1), the position becomes eligible for liquidation. It is the primary risk indicator for users and liquidators.

• Formula: (Collateral Value * Collateral Factor) / (Borrowed Value + Accrued Interest)
• Example: A position with $10,000 ETH collateral and a $5,000 USDC loan might have a Health Factor of 2.0. If ETH price drops 30%, the factor could fall below the threshold.

The specific Health Factor value at which a position becomes eligible for liquidation, set by the lending protocol. It acts as a buffer below the theoretical insolvency point (HF = 1.0) to account for price volatility and ensure liquidators have time to act.

• Typical Range: Between 1.0 and 1.5.
• Purpose: Provides a safety margin to protect the protocol from bad debt.
• Variable by Asset: Riskier collateral assets may have lower thresholds.

A discount offered to liquidators when they purchase a borrower's collateral, serving as the economic incentive for the liquidation process. The liquidator repays part of the debt in exchange for collateral worth more than the repaid amount.

• Mechanism: Also known as a liquidation penalty for the borrower.
• Typical Range: 5% to 15%.
• Example: A liquidator repays $100 of debt to seize $108 worth of collateral, earning an $8 (8%) bonus.

The smart contract subsystem that manages the liquidation process. It defines the rules for eligibility, the auction or fixed-discount mechanism, and the settlement logic. Key functions include:

• Checking Health Factors across all positions.
• Executing liquidations via public function calls.
• Distributing the liquidation bonus and repaying the debt pool.
• Handling partial liquidations to restore positions to health.

Unrecoverable debt that occurs when a position's collateral value falls below its debt value and no liquidator is able to close the position in time. This represents a loss for the protocol's lenders.

• Causes: Extreme market volatility, illiquid collateral, or network congestion preventing liquidations.
• Mitigation: Protocols use liquidation thresholds, insurance funds, and protocol-owned surplus to cover bad debt.

The two primary mechanisms for selling collateral.

• Fixed-Price (Instant): The most common method. Liquidators purchase collateral at a pre-defined discount (liquidation bonus) via a single transaction. Fast and simple.
• Dutch Auction: The collateral is offered at a starting price that decreases over time. Designed to improve fairness and price discovery in volatile markets or for large, illiquid positions. Used by protocols like MakerDAO.

All liquidation systems are governed by a set of critical, adjustable parameters that define their risk profile and behavior:

• Liquidation Threshold/Collateral Factor: The maximum loan-to-value (LTV) ratio before liquidation is enabled.
• Liquidation Penalty/Bonus: The incentive paid to the liquidator, taken from the borrower's collateral.
• Close Factor: The maximum portion of debt that can be liquidated in a single block (limits market impact).
• Health Factor / Collateralization Ratio: The real-time metric that determines a position's safety.
• Liquidation Reserve: A small fee held back from borrowers to cover gas costs of liquidation. These parameters are often set and adjusted via governance votes by token holders.

When a borrower's collateralization ratio falls below the protocol's liquidation threshold, their position becomes eligible for liquidation. A liquidation bot or keeper can then repay a portion of the borrowed assets (the debt) in exchange for a discounted portion of the collateral, known as the liquidation bonus. This process is atomic, restoring the position's health and penalizing the borrower.

• Trigger: Health Factor < 1 (e.g., on Aave, Compound).
• Execution: Liquidator repays debt, seizes collateral at a discount.
• Outcome: Borrower's debt is reduced, but they lose collateral.

The liquidation price is the asset price at which a position becomes undercollateralized. It's calculated based on the collateral amount, debt amount, and liquidation threshold. A critical risk is liquidation cascades, where many positions are liquidated simultaneously, causing rapid price drops and triggering more liquidations. To mitigate this, users maintain a margin of safety by over-collateralizing and monitoring prices.

• Formula: Liquidation Price ≈ (Debt * Collateral Factor) / Collateral
• Risk: High volatility can push prices to the threshold quickly.

Protocols use a system of penalties and incentives to ensure liquidations occur promptly. The borrower pays a liquidation penalty (or liquidation fee), which is added to their debt. The liquidator receives a liquidation bonus (e.g., 5-15% discount on the seized collateral), making the role profitable. This creates a competitive keeper network that monitors the blockchain for undercollateralized positions.

• Borrower Cost: Loss of collateral + penalty fee.
• Liquidator Incentive: Discounted asset purchase.
• Protocol Safety: Ensures bad debt is minimized.

Liquidation mechanisms are targets for exploitation. Key vulnerabilities include:

• Oracle Manipulation: Attackers manipulate the price feed (oracle) to trigger false liquidations.
• Liquidation Sandwiching: A malicious liquidator front-runs a legitimate liquidation transaction to capture the bonus.
• Gas Wars: During market volatility, liquidators engage in priority fee bidding, making liquidation unprofitable and risking protocol insolvency.
• Flash Loan Attacks: Using flash loans to dramatically lower a position's health factor for a targeted liquidation.

Borrowers can take several steps to avoid liquidation:

• Conservative Collateralization: Use a higher initial collateral factor than the minimum.
• Asset Diversification: Avoid using highly volatile or correlated assets as sole collateral.
• Active Monitoring: Use tools to track health factor and set up price alerts.
• Understanding Parameters: Know the specific liquidation threshold, close factor, and penalty for your chosen protocol.
• Using Stablecoins: Borrowing against stablecoin collateral reduces price volatility risk.

DeFi protocols implement safeguards to stabilize the liquidation process:

• Circuit Breakers: Some protocols pause liquidations during extreme volatility.
• Gradual Liquidations: Using a close factor to liquidate positions in portions, not all at once.
• Robust Oracle Design: Using decentralized, time-weighted average price (TWAP) oracles to resist manipulation.
• Insurance Funds & Reserve Factors: Protocols accumulate fees to cover bad debt from unsuccessful liquidations.
• Isolated Collateral Modes: Limiting which assets can be used together to prevent contagion.