Collateral and Liquidation
Overcollateralized System
DeFi lending uses an overcollateralized approach. You must deposit assets worth more than the amount you're borrowing.
Why overcollateralized?
- Anonymity: Borrower's identity and credit are unknown
- Volatility: Collateral value can drop rapidly
- Automation: Code makes decisions, not humans
If collateral becomes worth less than the borrowed amount, the protocol incurs losses. To prevent this, a mechanism for automatic liquidation before value drops is needed.
Key Terms
LTV (Loan-to-Value)
Maximum borrowing ratio relative to collateral
Example: If ETH's LTV is 80%
- Deposit $1,000 collateral → Can borrow up to $800
Liquidation Threshold
The threshold at which liquidation begins
Example: If liquidation threshold is 82.5%
- When borrowed amount exceeds 82.5% of collateral value, becomes eligible for liquidation
Always LTV < Liquidation Threshold. The gap between them is the safety buffer.
Health Factor
An indicator showing position health
Health Factor = (Collateral × Liquidation Threshold) / Borrowed Amount
| Health Factor | Status |
|---|---|
> 2.0 | Very Safe |
| 1.5~2.0 | Safe |
| 1.1~1.5 | Caution Needed |
| 1.0~1.1 | Danger! Liquidation Imminent |
< 1.0 | Eligible for Liquidation |
Liquidation occurs when Health Factor falls below 1.0.
Liquidation Penalty
Additional cost deducted from collateral during liquidation
Example: 5% liquidation penalty
- During liquidation, 5% of collateral goes to the liquidator as a bonus
Liquidation Process
Step 1: Health Factor Decline
Health factor drops below 1.0 due to collateral price decline or interest accumulation.
Step 2: Liquidator Intervention
A Liquidator repays part of the borrower's debt. Liquidators are bots or professional traders.
Step 3: Collateral Receipt
The liquidator receives collateral equal to the repaid amount + liquidation penalty.
Step 4: Position Resolution
Borrowed amount decreases and health factor recovers. Often only a portion, not the entire position, is liquidated.
Example
Initial State:
- Collateral: 1 ETH ($3,000)
- Borrowed: 2,400 USDC
- LTV: 80%, Liquidation threshold: 82.5%
- Health Factor: (3,000 × 0.825) / 2,400 = 1.03
ETH drops to $2,850:
- Health Factor: (2,850 × 0.825) / 2,400 = 0.98 → Eligible for liquidation!
Liquidation Occurs (50% partial liquidation):
- Liquidator repays 1,200 USDC
- Collateral liquidator receives: 1,200 / 2,850 × 1.05 = 0.442 ETH
- Remaining position: 0.558 ETH, 1,200 USDC debt
- New Health Factor: (0.558 × 2,850 × 0.825) / 1,200 = 1.09
Liquidation Penalty Comparison
| Protocol | Collateral Type | Liquidation Penalty |
|---|---|---|
| Aave V3 | ETH | 5% |
| Aave V3 | Stablecoins | 4% |
| Compound V3 | Most | 5~10% |
| MakerDAO | ETH | 13% |
Higher liquidation penalties are worse for borrowers but provide greater incentive for liquidators.
Types of Liquidation
Soft Liquidation
Used by some protocols (Curve Lending's LLAMMA).
- Collateral gradually converts to stablecoins as price drops
- Converts back to collateral when price recovers
- Smoother experience than traditional liquidation
- However, repeated conversions cause losses
Hard Liquidation
The traditional method used by most protocols.
- Health Factor < 1 → Immediate liquidation
- Liquidation penalty applies
- Fast and certain but costly for borrowers
Liquidation Prevention Strategies
1. Maintain Conservative LTV
Borrow only 50~60% of maximum LTV
Example: ETH LTV 80%
- Can borrow up to $800 but
- Borrow only $400~480 to maintain buffer
2. Monitor Health Factor
Maintain at least 1.5, take immediate action below 1.2
Position dashboards available on Aave, DeBank, etc.
3. Set Price Alerts
Set alerts for when collateral price falls below certain levels.
- TradingView alerts
- DeBank alerts
- Dedicated bots (DeFi Saver, etc.)
4. Add Collateral
When health factor drops, stabilize by depositing additional collateral.
5. Repay Debt
Repay some borrowed amount to reduce LTV.
6. Automated Liquidation Prevention Services
DeFi Saver: Automatically adds collateral or repays debt when health factor reaches threshold.
- Automated protection
- Fees apply
- Gas required
7. Use Stablecoin Collateral
Using stablecoins as collateral eliminates price fluctuation risk, reducing liquidation risk. (However, problems arise if the borrowed asset increases in price)
Responding to Liquidation Scenarios
Scenario 1: Gradual Decline
Collateral price drops over several days.
Response:
- Monitor health factor
- Add collateral or partial repayment below 1.3
- Consider full repayment after evaluating market conditions
Scenario 2: Sudden Crash
Flash crash causes instant price plunge.
Response Difficulty:
- May not have enough reaction time
- Gas fee spikes can delay transactions
- Prevention is the only solution
Scenario 3: Near-Liquidation Recovery
Health factor drops to 0.95 then price recovers.
Caution:
- Even if not liquidated, it's a warning sign
- Position needs review
- Adjust to more conservative LTV
Becoming a Liquidator
Liquidation is an open system anyone can participate in.
How It Works
- Scan for liquidation-eligible positions (Health Factor < 1)
- Execute debt repayment transaction
- Receive collateral + liquidation bonus
- Sell collateral to realize profit
Requirements
- Hold assets to repay (or use flash loans)
- Fast bot infrastructure
- MEV strategies to win gas fee competition
Reality
The liquidation market is very competitive. Professional MEV bots capture most liquidations. It's difficult for average users to profit as liquidators.
Partial vs Full Liquidation
Partial Liquidation
- Only part of the borrowed amount is liquidated
- Just enough to recover health factor above 1.0
- Minimizes borrower losses
Default for Aave, Compound
Full Liquidation
- Entire position is liquidated
- Simpler but worse for borrowers
Liquidation Limits
Each protocol has a maximum ratio that can be liquidated at once.
- Aave: Up to 50% (default)
- Compound V3: Varies by situation
Summary
In DeFi lending's overcollateralized system, liquidation is the core mechanism that maintains protocol health. Liquidation begins when health factor falls below 1.0, with liquidation penalties applied. Maintaining conservative LTV, monitoring health factor, and using automation tools can prevent liquidation. Prevention is the best defense against sudden price movements, and always consider worst-case scenarios when operating borrowed positions.
Next article: Flash Loans - The Secret of Unlimited Uncollateralized Loans