Decentralized Finance (DeFi) has revolutionized how individuals access credit, enabling trustless borrowing and lending through smart contracts. At the heart of this system lies a critical mechanism: liquidations. Without effective liquidation protocols, DeFi platforms would be vulnerable to bad debt and systemic risk. This article dives into how liquidations work across major lending protocols like Compound, Maker, and Aave V2, explaining why they're essential for maintaining financial stability in overcollateralized lending systems.
Whether you're new to DeFi or looking to deepen your understanding of risk management in decentralized lending, this guide breaks down complex mechanisms into clear, actionable insights.
Why Overcollateralization Matters in DeFi
In traditional finance, borrowers often pledge assets—like homes or vehicles—as collateral for loans. DeFi follows a similar principle but with one crucial difference: overcollateralization is mandatory.
Unlike traditional banks that may offer 100% or even higher loan-to-value (LTV) ratios, DeFi protocols require users to deposit more in value than they wish to borrow. For example, if you want to borrow $1,000 worth of stablecoins, you might need to lock up $1,500 in ETH as collateral.
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This buffer exists because there are no credit checks or legal enforcement mechanisms in decentralized systems. Instead, the protocol relies on economic incentives and automated processes to ensure solvency.
If the value of your collateral drops too close to—or below—the amount you’ve borrowed, the position becomes undercollateralized. At that point, it poses a threat to the entire system, potentially leading to bad debt, where the protocol cannot recover lent funds.
Bad debt erodes user trust and can trigger cascading failures during market downturns—similar to a bank run. That’s why preventing undercollateralized positions is not just beneficial; it's existential for DeFi lending platforms.
How Liquidations Prevent Bad Debt
To mitigate the risk of bad debt, DeFi protocols use liquidations—automated processes that allow third parties (known as liquidators) to repay a portion of an unhealthy borrower’s debt in exchange for a discounted amount of their collateral.
Here’s how it works:
- When a borrower’s collateral value falls below a predefined threshold, their position becomes eligible for liquidation.
- Any participant can step in, repay part of the debt, and receive more value in collateral than what they paid—typically due to a liquidation bonus (e.g., 5–10% discount).
- This incentivizes quick action, ensuring positions are closed before losses accumulate.
But why rely on external actors instead of automating everything within the protocol?
There are two main reasons:
- Gas Efficiency: Automated liquidations would require constant monitoring and execution by the protocol itself, dramatically increasing operational costs.
- Market Responsiveness: Human or bot-driven liquidators can react faster and more efficiently to volatile markets than a rigid on-chain mechanism.
Liquidations are only profitable when the collateral value exceeds the debt—so protocols must define precise thresholds that give liquidators enough time and incentive to act.
Key DeFi Protocols and Their Liquidation Models
Different platforms implement liquidation logic in unique ways. Let’s examine three major players: Compound, MakerDAO, and Aave V2.
Compound: Calculating Account Liquidity
Compound uses a concept called account liquidity to determine whether a position is safe or subject to liquidation.
The core function, getAccountLiquidity(), evaluates all assets a user has deposited as collateral and all debts they’ve taken out. It calculates:
Available Liquidity = Total Collateral Value × Collateral Factor – Total Borrowed ValueEach asset has a collateral factor (e.g., 0.75), representing the maximum percentage of its value that can be borrowed against. For instance, with $1,000 in ETH at a 75% collateral factor, you can borrow up to $750 worth of assets.
If available liquidity goes negative, the account is at risk. Compound caps the maximum collateral factor at 90%, meaning no asset allows borrowing more than 90% of its value.
Oracle price feeds provide real-time valuation in USD, ensuring accurate risk assessment across volatile assets.
MakerDAO: The "Bite" and "Bark" Triggers
MakerDAO refers to borrowing positions as vaults. A vault becomes unsafe when:
Collateral Value × Liquidation Ratio < Debt × Stability FeeTwo smart contracts handle liquidations:
Cat.bite()– Legacy system (Liquidation 1.2)Dog.bark()– Upgraded system (Liquidation 2.0)
Both check the same condition: if the vault’s collateral value (adjusted by a safety margin) is less than its debt (including accrued interest), it's marked for liquidation.
Maker uses DAI, its native stablecoin, to price both collateral and debt. The spot price from oracles is adjusted by a liquidation penalty (usually 13%), meaning liquidators buy collateral at a discount while the system recoups losses.
This design ensures rapid response during crashes while discouraging reckless borrowing.
Aave V2: Health Factor Explained
Aave V2 introduces a metric called the Health Factor (HF):
Health Factor = (Total Collateral in ETH × Avg Liquidation Threshold) / Total Debt in ETHWhen HF < 1, the position is eligible for liquidation.
Each asset has its own liquidation threshold, set by governance via risk advisors like Gauntlet. For example:
- ETH might have an 80% threshold → $1,000 in ETH supports up to $800 in borrowing power.
- Riskier tokens may have thresholds as low as 50%.
Aave prices everything in ETH, providing consistency across assets. The health factor gives users a single number to monitor their risk exposure.
Real-World Example: A Deep Underwater Position
Let’s analyze a real case from Aave V2: address 0x227cAa7eF6D955A92F483dB2BD01172997A1a623.
At its peak:
- Total Debt: ~17.8 ETH
- Total Collateral: Only ~0.0136 ETH
This means the borrower owed over 1,300 times more than their remaining collateral—a clear sign of distress.
What happened?
The user borrowed 700,000 MANA when its price was ~0.000328 ETH per token (~$1.45 each). Within hours, MANA’s price surged over 2.6x to ~0.00086 ETH—increasing the debt burden dramatically.
Despite depositing additional DAI and ETH shortly after borrowing, the position quickly became toxic.
Over 87 separate liquidation events occurred between blocks 13,520,838 and 13,522,070. Liquidators seized:
- ~50 ETH
- ~387,663 DAI
Yet even after these interventions, the final state showed:
- Remaining Collateral: ~0.6 ETH
- Outstanding Debt: ~45.27 ETH
Why wasn’t it fully cleared?
Because Aave limits each liquidation to 50% of the outstanding debt (LIQUIDATION_CLOSE_FACTOR_PERCENT). This prevents market manipulation and excessive sell pressure from large-scale liquidations.
Additionally, low liquidity in certain assets makes full repayment impractical without slippage or high gas costs.
Ultimately, this position resulted in bad debt, underscoring the importance of timely intervention and well-calibrated thresholds.
Frequently Asked Questions (FAQ)
What triggers a liquidation in DeFi?
A liquidation occurs when the value of a borrower’s collateral drops below a protocol-defined threshold relative to their debt. This is monitored using price oracles and calculated via metrics like Health Factor or account liquidity.
Can I avoid being liquidated?
Yes. You can:
- Maintain a conservative LTV ratio.
- Monitor your position regularly.
- Add more collateral or repay debt proactively.
- Use alerts or automated tools to track price movements.
Who can perform a liquidation?
Anyone with sufficient funds can act as a liquidator. Bots often dominate this space due to speed and precision in executing profitable opportunities.
Do liquidators always profit?
Not guaranteed. If market conditions change rapidly (e.g., oracle delays or flash crashes), liquidators may suffer losses—especially if they overpay or face high gas fees.
Why don’t protocols liquidate entire positions at once?
Large-scale liquidations can crash asset prices due to sudden sell-offs. By limiting the size per transaction (e.g., Aave’s 50%), protocols reduce systemic risk and maintain market stability.
What happens if no one liquidates a bad position?
Unliquidated positions create bad debt—money the protocol cannot recover. This weakens reserves and can undermine confidence in the platform during downturns.
Core Principles Across Protocols
Despite differences in implementation, all major DeFi lending platforms share common principles:
- Overcollateralization is mandatory
- Liquidation thresholds are asset-specific and risk-adjusted
- Price oracles provide real-time valuation
- Third-party liquidators are incentivized with discounts
- Governance adjusts parameters based on market volatility
These mechanisms collectively ensure that DeFi remains resilient—even in extreme market conditions.
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Understanding liquidations isn’t just about avoiding personal loss—it’s about grasping how decentralized systems maintain trust without intermediaries.
As DeFi evolves, innovations in risk modeling, oracle accuracy, and incentive alignment will continue shaping the future of open finance.
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Core Keywords: DeFi lending, liquidation process, overcollateralization, health factor, liquidation threshold, bad debt prevention, smart contract risk, DeFi protocols