Partial Liquidation

Partial liquidation is a risk mitigation mechanism used in overcollateralized lending protocols like Aave and Compound. It is triggered when a user's health factor or collateral ratio falls below a predefined safety threshold but remains above the level that would necessitate a full liquidation. Instead of closing the entire loan position, the protocol's liquidation bots or keepers sell a calculated portion of the borrower's collateral on the open market, using the proceeds to repay a corresponding portion of the outstanding debt. This action increases the remaining collateral ratio, bringing the position back to a safe state.

The primary goal is to protect the protocol's solvency while minimizing disruption for the borrower. For example, if ETH price drops, causing a user's loan-to-value (LTV) to rise dangerously, a partial liquidation might sell 30% of their collateralized ETH to repay 30% of their borrowed USDC. This is less punitive than a full liquidation, which would close the position entirely, incur higher penalty fees, and leave the borrower with no remaining collateral. The exact amount liquidated is calculated by the protocol's smart contracts to restore the health factor to just above the safe threshold.

Key technical aspects include the liquidation threshold, which determines when the process begins, and the liquidation penalty, a fee added to the debt repaid, which serves as an incentive for liquidators. The mechanism relies on liquidation bots competing to execute these transactions for profit. This design creates a more resilient system by allowing positions to be corrected gradually during market volatility, reducing systemic risk and potential bad debt for the protocol, compared to the all-or-nothing approach of traditional full liquidations.

Partial liquidation is a risk management mechanism in decentralized finance (DeFi) lending protocols where only a portion of an undercollateralized position is automatically closed to restore its financial health. It is triggered when a user's health factor—a ratio of collateral value to borrowed value—drops below a predefined liquidation threshold but remains above the level that would necessitate a full liquidation. This process involves a liquidator (a bot or user) purchasing a calculated amount of the user's collateral at a discount, using the proceeds to repay a corresponding portion of the user's outstanding debt, and keeping the discount as profit. The primary goal is to deleverage the position incrementally, giving the borrower a chance to rectify their collateralization without losing their entire stake.

The mechanics are governed by precise, on-chain calculations. When the health factor dips into the 'liquidation zone,' the protocol calculates a liquidation bonus (or discount) and a close factor. The close factor determines the maximum percentage of the borrowed assets that can be liquidated in a single transaction, often capped (e.g., 50%). The liquidator repays that portion of the debt and receives an equivalent value of the borrower's collateral, plus the bonus. For example, with a 5% liquidation bonus, repaying $100 of debt might grant the liquidator $105 worth of collateral. This action increases the remaining position's health factor, ideally bringing it back above the safe threshold. Protocols like Aave and Compound implement variations of this model.

This mechanism benefits all parties involved. For the borrower, it acts as a buffer, preventing total loss and allowing for recovery by adding more collateral or repaying debt. For the protocol, it mitigates systemic risk by ensuring bad debt is resolved promptly, protecting the solvency of the lending pool. For liquidators, it creates a competitive market for providing this essential service, incentivized by the liquidation bonus. The process is typically executed in a single blockchain transaction via smart contracts, ensuring transparency and immutability. Parameters like liquidation thresholds, bonuses, and close factors are set by protocol governance and are critical to the system's stability and user experience.

Key considerations include liquidation penalties, which are fees paid by the borrower from their collateral, and liquidation efficiency, which depends on market liquidity and bot competition. In volatile markets, a cascade of partial liquidations can occur if asset prices continue to fall. Advanced users may employ strategies like setting up health factor alerts or using debt recycling techniques to manage their positions proactively. Understanding partial liquidation is crucial for anyone engaging in DeFi borrowing, as it defines the precise conditions under which their collateral is at risk and the safety nets provided by the protocol's design.

A partial liquidation is triggered when a borrower's collateralization ratio falls below the protocol's liquidation threshold but remains above the level that would necessitate a full account closure. This automated process begins with a liquidation bot or keeper detecting the undercollateralized position on-chain. The liquidator then repays a portion of the borrower's outstanding debt, typically up to a close factor limit (e.g., 50%), in exchange for a discounted seizure of a corresponding portion of the borrower's collateral, plus a liquidation bonus as an incentive.

The execution follows a precise mathematical formula. For example, if a borrower has 10 ETH as collateral and a debt of 15,000 DAI, and the price of ETH drops so the health factor falls to 0.95 (below the 1.0 threshold), a liquidator might repay 5,000 DAI of the debt. In return, they receive a calculated amount of ETH collateral, valued at slightly less than 5,000 DAI, with the discount (e.g., 5%) serving as their profit. This reduces the borrower's debt and improves their health factor, ideally bringing it back above the dangerous threshold.

This mechanism is crucial for protocol solvency, as it ensures bad debt is minimized without wiping out the borrower entirely. The borrower retains the majority of their collateral and can continue using the protocol, albeit with a reduced position. Key parameters governing this process—liquidation threshold, close factor, and liquidation bonus—are set by governance and are visible in the protocol's smart contracts, creating a transparent and predictable system for managing risk.