Liquidation Threshold

The liquidation threshold is the maximum loan-to-value (LTV) ratio at which a borrower's collateral position is considered undercollateralized and can be liquidated by other network participants, known as liquidators. It is expressed as a percentage (e.g., 80%) and is set by the protocol's governance for each accepted collateral asset. When the health of a borrowing position, often measured by a health factor or collateral factor, falls below 1.0—meaning the borrowed value exceeds the liquidation threshold of the collateral's value—the position becomes eligible for liquidation to protect the protocol from bad debt.

This parameter is distinct from the loan-to-value (LTV) ratio, which is the maximum amount one can borrow against posted collateral. The liquidation threshold is always set higher than the LTV, creating a safety buffer or liquidation buffer. For example, if an asset has an 80% liquidation threshold and a 75% LTV, a user can borrow up to 75% of the collateral's value, but liquidation risk only begins when the borrowed amount exceeds 80% of the collateral's current value. This buffer gives borrowers time to add more collateral or repay debt before facing liquidation.

The threshold is calibrated based on the volatility and liquidity of the underlying collateral asset. Stablecoins like USDC typically have high thresholds (e.g., 85-90%) due to low price volatility, while more volatile assets like cryptocurrencies may have lower thresholds (e.g., 60-75%). A lower threshold acts as a more conservative risk measure, triggering liquidation earlier to ensure the protocol can recover the full loan amount even if the collateral's price drops rapidly during the liquidation process.

During a liquidation event, a liquidator repays a portion of the borrower's outstanding debt in exchange for the borrower's collateral, often at a liquidation bonus (a discount). This mechanism ensures the protocol remains solvent. The specific mechanics—such as the size of the bonus and the maximum liquidation amount—are defined by the protocol's smart contracts. Understanding this threshold is critical for risk management, as it directly impacts the margin of safety for any leveraged position in DeFi.

The liquidation threshold is the maximum collateralization ratio at which a user's position is considered safe; if the Loan-to-Value (LTV) ratio rises above this threshold due to market movements, the position becomes eligible for liquidation. This parameter is expressed as a percentage (e.g., 80%) and is set by the protocol's governance based on the volatility and liquidity of the specific collateral asset. It acts as a safety buffer below the asset's maximum LTV, creating a margin of safety for the protocol and its lenders.

When the value of a borrower's collateral falls, their health factor—a metric calculated from the collateral value, borrowed amount, and liquidation threshold—drops toward 1.0. Once the health factor falls below 1.0, the position is under-collateralized, meaning the collateral no longer sufficiently covers the loan. At this point, the protocol's liquidation mechanism is triggered. Liquidators—third-party bots or users—can repay a portion of the outstanding debt in exchange for seizing the borrower's collateral at a discounted price, known as a liquidation penalty.

The threshold is not uniform; it varies significantly by asset. For example, a stablecoin like USDC might have a high liquidation threshold (e.g., 85%) due to its price stability, while a more volatile asset like a memecoin might have a much lower threshold (e.g., 65%). This differentiation in risk parameters allows protocols to manage their overall risk exposure. The gap between the maximum LTV (the borrowing limit) and the liquidation threshold is the liquidation buffer, which gives borrowers time to add collateral or repay debt before facing liquidation.

Understanding this mechanism is crucial for risk management. Borrowers must monitor their health factor and the price of their collateral assets. A sudden market downturn can rapidly push multiple positions across the threshold simultaneously, leading to a liquidation cascade. This event can exacerbate price declines as liquidated collateral is sold on the open market, creating volatility and potential bad debt for the protocol if liquidations cannot keep pace with the falling prices.

A liquidation is the forced closure of a borrower's collateralized debt position (CDP) when its collateralization ratio falls below a predefined liquidation threshold. This automated process is triggered by a drop in the value of the deposited collateral or an increase in the borrowed asset's value. The primary purpose is to ensure that loans remain overcollateralized, protecting the lending protocol and its users from bad debt. A liquidator—often a bot or a user—repays a portion of the outstanding debt in exchange for the borrower's collateral, typically sold at a discount known as a liquidation penalty.

The process is governed by key parameters set by the protocol: the Loan-to-Value (LTV) ratio, which determines the maximum initial borrowing power, and the liquidation threshold, which is the LTV level at which a position becomes eligible for liquidation. For safety, the liquidation threshold is always set higher than the maximum LTV. For example, if a vault has a 75% maximum LTV, its liquidation threshold might be 80%. This creates a liquidation buffer or safety cushion, giving the borrower time to add collateral or repay debt before their position is liquidated.

When a position's health factor deteriorates past the threshold, it enters a state where any public participant can act as a liquidator. The liquidator repays the borrower's debt (or a portion of it) to the protocol. In return, they receive an equivalent value of the borrower's collateral, plus an incentive—the liquidation penalty. This penalty, often 5-15%, is designed to compensate the liquidator for their work and market risk. The remaining collateral, if any, is returned to the borrower. This mechanism ensures the loan is made whole for the protocol while efficiently clearing risky positions from the system.

Different protocols implement variations of this core model. Some, like MakerDAO, use a collateral auction system where liquidated collateral is sold to the highest bidder. Others, like Aave and Compound, use a fixed liquidation bonus where the liquidator can seize collateral at a below-market price. The specific mechanics—including the size of the penalty, the portion of debt repaid in a single transaction, and the oracle price feeds used—are crucial protocol design choices that affect market stability and user risk.