Liquidation Threshold

The liquidation threshold is the maximum Loan-to-Value (LTV) ratio at which a borrower's position remains safe from forced closure. If the value of the supplied collateral falls such that the loan's LTV exceeds this preset threshold, the position becomes under-collateralized and can be liquidated by any network participant. This mechanism protects lenders by ensuring loans are always sufficiently backed, even in volatile markets. It is distinct from the liquidation LTV, which is the exact ratio that triggers the liquidation event, and is typically set a few percentage points below the threshold to provide a buffer.

Protocols like Aave and Compound set unique thresholds for each collateral asset based on its perceived risk and market liquidity. For example, a stablecoin like USDC might have a high threshold (e.g., 85%), while a more volatile asset like a memecoin might have a much lower one (e.g., 40%). A user's Health Factor, a numerical representation of their position's safety, is calculated using this threshold: Health Factor = (Collateral Value * Liquidation Threshold) / Borrowed Value. A Health Factor dropping below 1.0 indicates the LTV has breached the threshold, initiating the liquidation process.

During liquidation, a liquidator repays a portion of the borrower's outstanding debt in exchange for the underlying collateral, often at a discounted rate known as a liquidation bonus. This process happens via smart contracts and is designed to be capital-efficient, restoring the loan's health factor above the safe threshold. For borrowers, understanding this parameter is essential for risk management, as it dictates how much market depreciation their position can withstand before facing penalties and loss of collateral.

The liquidation threshold is the maximum collateralization ratio at which a borrower's position becomes eligible for liquidation in a decentralized lending protocol. It is expressed as a percentage (e.g., 80%) and acts as a safety buffer for the protocol. When the loan-to-value (LTV) ratio of a position—calculated as (borrowed amount / collateral value) * 100—exceeds this threshold, the position is considered undercollateralized. At this point, liquidators (third-party actors) are incentivized to repay a portion of the debt in exchange for seizing and selling the borrower's collateral at a discount, ensuring the protocol remains solvent.

This mechanism is distinct from the liquidation LTV, which is often a higher, more severe level triggering immediate liquidation, and the liquidation penalty, which is the discount applied to the collateral seized. The threshold creates a liquidation zone between the initial maximum borrow LTV and the point of actual liquidation. For example, if ETH has a borrow LTV of 75% and a liquidation threshold of 80%, a user can borrow up to $750 against $1000 of ETH. If ETH's value drops, causing the LTV to rise above 80%, the position enters the danger zone and can be liquidated to protect the protocol's funds.

Setting the threshold involves a trade-off between capital efficiency and risk management. A higher threshold (e.g., 85%) allows users to borrow more against their collateral but increases protocol risk during market volatility. A lower threshold (e.g., 65%) is more conservative but reduces borrowing power. Protocols like Aave and Compound set unique thresholds per asset based on its volatility, liquidity, and oracle reliability. Stablecoins like USDC typically have higher thresholds (∼80-85%) than more volatile assets like crypto equities, which may have thresholds as low as 40-50%.

From a user's perspective, monitoring the health factor—a metric derived from the liquidation threshold—is essential. The health factor is calculated as (Collateral Value * Liquidation Threshold) / Total Borrowed. A health factor dropping below 1.0 indicates the liquidation threshold has been breached, triggering a liquidation event. Users must manage this risk by adding more collateral, repaying debt, or using debt refinancing strategies. Automated tools and liquidation protection services exist to alert users or automatically take corrective action when their position nears the threshold.

The liquidation process is an automated, non-negotiable enforcement mechanism in decentralized finance (DeFi) lending protocols. It is triggered when a borrower's Health Factor—a ratio of their collateral value to borrowed value—falls below 1.0, indicating their collateral is insufficient to cover the loan. This occurs because the value of the deposited collateral has decreased, the value of the borrowed asset has increased, or a combination of both. The primary purpose is to protect the protocol and its lenders from bad debt by ensuring all loans remain over-collateralized.

Once triggered, the process is typically executed by third-party actors known as liquidators. These are bots or individuals who monitor the blockchain for undercollateralized positions. They are incentivized to repay a portion (or all) of the borrower's outstanding debt in exchange for the right to seize the borrower's collateral at a discounted rate, known as a liquidation penalty. This discount, often between 5-15%, serves as the liquidator's profit and ensures rapid resolution of risky positions.

From the borrower's perspective, the event results in an irreversible loss of a portion of their collateral. For example, if Alice borrows 50 ETH against 100,000 USDC collateral and the ETH price surges, her collateral value in ETH terms plummets. If her Health Factor drops below 1.0, a liquidator can repay her 50 ETH debt and claim, say, 105,000 USDC of her collateral (a 5% bonus). The remaining collateral, minus any fees, is returned to Alice, but her position is closed.

This process is fundamental to the trustless design of DeFi. It replaces credit checks and margin calls with transparent, code-governed rules. Protocols carefully calibrate parameters like the Loan-to-Value (LTV) ratio, liquidation threshold, and penalty to balance borrower flexibility with system solvency. Visualizing this flow—from price oracle updates to Health Factor calculation, liquidation trigger, and keeper bot execution—reveals the intricate, automated plumbing that secures billions in decentralized loans.