Liquidation (DeFi)

How It Works

When a borrower's health factor drops below 1.0 (meaning their collateral value has fallen too close to their debt value), their position becomes eligible for liquidation. Third-party liquidators — typically automated bots — monitor the blockchain for liquidatable positions and compete to execute liquidations first.

The liquidator repays a portion of the borrower's debt (up to 50% in most protocols) directly to the lending pool. In return, the liquidator receives an equivalent value of the borrower's collateral plus a liquidation bonus (typically 5-15%). This discount incentivizes liquidators to act quickly, ensuring bad debt does not accumulate in the protocol.

Modern lending protocols like Aave v3 use efficient liquidation mechanisms where the entire process occurs in a single atomic transaction. Liquidators often use flash loans to execute liquidations without needing upfront capital — they borrow the repayment amount, perform the liquidation, sell the seized collateral, repay the flash loan, and pocket the profit, all in one transaction.

Why It Matters in DeFi

Liquidation is the enforcement mechanism that makes overcollateralized lending work. Without liquidation, borrowers whose collateral drops below their debt value would simply walk away, leaving lenders with losses. The liquidation system ensures that positions are closed before the debt exceeds the collateral value, protecting depositors who supply lending capital.

For traders, liquidation is a major risk. During rapid market crashes, cascading liquidations can amplify price declines — as liquidated collateral is sold on the market, it pushes prices further down, triggering more liquidations. Understanding liquidation thresholds and maintaining healthy collateral ratios is essential for any DeFi borrower.

Real-World Example

During the May 2022 market crash, Aave processed over $200 million in liquidations in a single day. A borrower with 100 ETH as collateral and $150,000 USDC debt saw their health factor drop below 1.0 as ETH fell from $2,000 to $1,600. A liquidator bot repaid $75,000 of the debt and received approximately $81,000 worth of ETH (at the 8% liquidation bonus). The borrower retained their remaining collateral minus the seized amount, and the lending pool remained fully solvent.