Liquidation Threshold

The liquidation threshold is the percentage of a loan's collateral value at which a borrower's position is considered undercollateralized and can be liquidated by other users. Its primary purpose is to protect lenders by ensuring the loan is always sufficiently backed, even if the collateral's market price falls. For example, a 75% threshold means liquidation can begin if the collateral value drops to 75% of the loan value.

The liquidation threshold works in tandem with the Loan-to-Value (LTV) ratio to define a "safety buffer" or liquidation buffer.

• Maximum LTV: The initial borrowing limit (e.g., 50%).
• Liquidation Threshold: The point where liquidation is triggered (e.g., 75%).
• Liquidation Buffer: The difference (e.g., 25%) that provides a margin of safety against price volatility before the position is at risk.

Each DeFi protocol sets unique liquidation thresholds based on collateral asset risk. More volatile assets have lower thresholds.

• Aave & Compound: Publish explicit thresholds per asset (e.g., ETH: 82.5%, WBTC: 75%).
• MakerDAO: Uses a similar concept via its Liquidation Ratio for each Vault type.
• Liquidators: Are incentivized with a liquidation bonus (or penalty) for closing underwater positions, which is factored into the threshold calculation.

The liquidation threshold is central to calculating a position's Health Factor (HF).

• Formula: Health Factor = (Collateral Value * Liquidation Threshold) / Total Borrowed Value.
• HF > 1: Position is safe.
• HF <= 1: Position is at or below the liquidation threshold and can be liquidated. Users must monitor their HF and add collateral or repay debt to avoid liquidation, which incurs significant penalties.

For risk managers and analysts, the liquidation threshold is a key metric for assessing protocol risk and collateral quality.

• Aggregate Analysis: Monitoring the total value of collateral near its threshold across a protocol indicates systemic risk.
• Stress Testing: Models simulate price drops to see how many positions would be liquidated.
• Asset Listing: New collateral types are assigned thresholds based on historical volatility, liquidity, and oracle reliability.

Protocols differ in how they set and apply this critical parameter:

• Granularity: Asset-specific (Aave) vs. global (Liquity).
• Governance: Set by DAO (Aave, Compound) or market creators (Morpho).
• Liquidation Mechanism: Fixed-price auctions (Maker), stability pools (Liquity), or direct keeper sales (Aave, Compound).
• Related Metrics: Often paired with a Liquidation Bonus/Penalty and a Health Factor or Collateralization Ratio to manage system solvency.

The liquidation threshold is the collateral value ratio (e.g., 80%) at which a user's borrowed position becomes undercollateralized and can be liquidated by other network participants. It is a protocol-set parameter, distinct from the Loan-to-Value (LTV) ratio, and acts as a safety buffer. When the health factor (a metric comparing collateral value to borrowed value) falls below 1 due to market movements, the position crosses this threshold, triggering a liquidation event to repay the debt and protect the protocol.

The Liquidation Threshold and Loan-to-Value (LTV) ratio are paired risk parameters but serve different functions.

• Maximum LTV: The initial borrowing limit (e.g., 75% for ETH). You can only borrow up to this percentage of your collateral's value.
• Liquidation Threshold: The higher, critical threshold (e.g., 82% for ETH) where liquidation begins. The gap between LTV and the liquidation threshold creates a safety buffer or liquidation buffer. This buffer absorbs price volatility, preventing immediate liquidations from normal market fluctuations.

A user's risk is determined by their position's Health Factor, which is calculated using the liquidation threshold.

Formula (simplified): Health Factor = (Collateral Value * Liquidation Threshold) / Total Borrowed Value

• Health Factor > 1: Position is safe.
• Health Factor <= 1: Position is at or below the liquidation threshold and subject to liquidation.

Example: With $10,000 of ETH collateral (liquidation threshold: 80%) and a $6,000 stablecoin debt: Health Factor = ($10,000 * 0.80) / $6,000 = 1.33 The price of ETH would need to drop ~25% to trigger liquidation.

Once the liquidation threshold is breached, a liquidation occurs:

• A liquidator (a bot or user) repays part or all of the borrower's outstanding debt.
• In exchange, they can purchase the borrower's collateral at a discount (a liquidation penalty), generating a profit.
• The borrower loses a portion of their collateral. This penalty, often 5-15%, is a key risk and is added to the debt being repaid.
• The process is automated via smart contracts and happens rapidly, often within a single blockchain transaction.

Protocols assign different liquidation thresholds based on an asset's risk profile.

High-Threshold / Low-Risk Assets (e.g., 80-85%):

• Major, liquid assets like ETH or wBTC.
• Deemed stable and easy to sell.

Low-Threshold / High-Risk Assets (e.g., 40-65%):

• Volatile or less liquid altcoins.
• Newer or more speculative assets.

This tiering protects the protocol; riskier collateral requires more overcollateralization, providing a larger buffer against price drops.

To avoid crossing the liquidation threshold, borrowers should:

• Monitor Health Factor Continuously: Use dashboards or alerts.
• Maintain a Large Safety Buffer: Borrow significantly less than the maximum LTV allows.
• Top Up Collateral: Add more collateral if the asset price falls.
• Repay Debt: Partially repay the loan to improve the Health Factor.
• Understand Asset Parameters: Know the specific LTV and liquidation threshold for each collateral asset, as they can be changed via governance votes.

The Liquidation Bonus (or discount) is an incentive paid to liquidators for closing unsafe positions. It is a percentage discount applied to the collateral's market value when seized.

• Mechanism: A liquidator repays part of the unhealthy debt in exchange for collateral valued at a discount (e.g., 5%).
• Purpose: This bonus compensates liquidators for risk and transaction costs, ensuring the liquidation system remains solvent and efficient even during high network congestion.

Maximum LTV is often used synonymously with the basic Loan-to-Value (LTV) ratio, representing the absolute borrowing limit. It is the primary guardrail against over-leverage set by the protocol.

• Key Distinction: The Liquidation Threshold is a higher value that determines when a position is at risk, while the Maximum LTV determines how much can be borrowed initially.
• The gap between these two values is the protocol's designed margin of safety for the borrower.

Primarily used in Compound Finance, the Collateral Factor is functionally equivalent to the Liquidation Threshold. It is the percentage of a collateral asset's value that can be borrowed against before the position becomes liquidatable.

• Example: An ETH collateral factor of 80% means borrowing up to $80 against $100 of ETH is allowed, and liquidation occurs if the borrowed value exceeds this threshold.
• This term highlights how the same core risk parameter is named differently across lending protocols.

The Close Factor is a protocol parameter that limits how much of an unhealthy position a single liquidator can close in one transaction, expressed as a percentage of the outstanding borrow.

• Purpose: It prevents a single liquidator from monopolizing a large liquidation and allows multiple participants to compete, potentially leading to better execution prices.
• Interaction: It works in tandem with the Liquidation Threshold; the threshold defines when liquidation can occur, while the close factor defines how much can be liquidated at once.