Auto-Liquidation

The Health Factor is the core metric determining liquidation risk. It's calculated as (Collateral Value * Liquidation Threshold) / Borrowed Value. When this ratio drops below 1.0, the position becomes eligible for auto-liquidation. The Liquidation Threshold is the maximum loan-to-value (LTV) ratio at which collateral can be borrowed against, set per asset based on its volatility.

To incentivize third-party liquidators (often bots) to repay the bad debt, protocols offer a liquidation bonus or discount. This allows liquidators to purchase the undercollateralized assets at a price below market value (e.g., a 5-10% discount). This bonus covers gas costs and provides profit, ensuring the system remains solvent.

1. Monitoring: Oracles update collateral prices.
2. Check: Protocol calculates the Health Factor.
3. Trigger: Health Factor falls below 1.0.
4. Execution: A liquidator's transaction repays part or all of the debt.
5. Seizure: The corresponding collateral, plus the bonus, is transferred to the liquidator.
6. Closure: If the debt is fully repaid, the remaining collateral is returned to the borrower.

Protocols often use partial liquidation to minimize market impact and give borrowers a chance to recover. A fixed percentage of the debt is repaid (e.g., 50%), raising the Health Factor back above the safe threshold. Full liquidation occurs if the position is severely undercollateralized or if partial actions fail to restore health, closing the position entirely.

Borrowers face a liquidation penalty, a fee added to the debt amount being repaid. This penalty is separate from the liquidator's bonus and is paid to the protocol's treasury or reserve fund as a security fee. It acts as a deterrent against excessive risk-taking.

• Oracle Manipulation: Incorrect price feeds can trigger false liquidations.
• Liquidity Crunch: During market crashes, insufficient liquidity can cause liquidation cascades.
• Maximizing Extractable Value (MEV): Liquidations are prime targets for MEV, where bots compete via priority gas auctions, increasing costs.
• Gas Price Volatility: Network congestion can delay liquidations, increasing protocol bad debt.

The Liquidation Threshold is the Loan-to-Value (LTV) ratio at which a position becomes eligible for liquidation. For example, if ETH has an 80% threshold, a position is at risk when the value of the borrowed assets reaches 80% of the collateral value. This buffer protects the protocol by ensuring liquidation occurs before the collateral value falls below the debt value.

The Liquidation Penalty (or Liquidation Bonus) is the discount granted to liquidators for repaying the bad debt. It incentivizes rapid market response. For instance, a 10% penalty means a liquidator can repay $100 of debt to claim $110 worth of the user's collateral. This fee is a cost to the liquidated user and a key component of the protocol's economic security.

The Health Factor is a real-time metric representing a position's safety margin against liquidation. It is calculated as (Collateral Value * Liquidation Threshold) / Debt Value. A health factor of 1.0 is the liquidation threshold. Values below 1.0 trigger liquidation, while higher values indicate a safer position. This is the primary dashboard metric for users.

The Close Factor determines the maximum portion of a position's debt that can be liquidated in a single transaction. It limits market impact and prevents a single liquidation from dumping all collateral at once. A common close factor is 50%, meaning a liquidator can only repay up to half the debt in one go, potentially requiring multiple liquidations to fully close the position.

A Liquidation Reserve (or Liquidation Incentive Reserve) is a portion of the collateral set aside to guarantee liquidators are compensated even if the liquidation process itself incurs gas costs or slippage. This ensures the liquidation mechanism remains economically viable under all network conditions, preventing 'liquidation black holes' where no one is incentivized to act.

Reliable Price Oracle data is the foundational input for all liquidation math. The Deviation parameter (or Oracle Tolerance) defines the maximum acceptable price difference between oracles before the system pauses liquidations to prevent manipulation. For example, a 2% deviation threshold would halt actions if oracle prices diverge by more than 2%, protecting users from flash crashes on a single exchange.

A liquidation is triggered when a borrower's Health Factor (or Collateral Factor) falls below 1.0. This occurs when the value of the borrowed assets exceeds the value of the posted collateral, adjusted by a Loan-to-Value (LTV) ratio. For example, if ETH drops in price, the collateral backing a DAI loan may become insufficient, prompting the protocol to initiate liquidation to protect lenders.

When triggered, a portion of the borrower's collateral is sold (often via a liquidation auction or direct sale to a liquidation bot) to repay the outstanding debt plus a liquidation penalty (or bonus). This penalty, typically 5-15%, is paid to the liquidator as an incentive and is an additional loss for the borrower. The remaining collateral, if any, is returned to the borrower.

In volatile markets, a sharp price drop can cause mass liquidations. As liquidators sell large amounts of collateral (e.g., ETH), it can drive the asset's price down further, triggering more liquidations in a positive feedback loop known as a liquidation cascade or death spiral. This was a major factor in the collapse of the Terra/LUNA ecosystem.

Auto-liquidation relies entirely on price oracles to determine collateral value. Risks include:

• Oracle latency: Stale prices can cause premature or delayed liquidations.
• Oracle manipulation: Attackers may exploit a protocol's oracle (e.g., via flash loans) to artificially lower the reported price, triggering unfair liquidations they can profit from, as seen in the bZx and Harvest Finance exploits.

The liquidation process itself can fail or be inefficient. If the market is illiquid, selling the collateral may incur high slippage, potentially leaving debt undercollateralized. Protocols use mechanisms like gradual liquidations (selling collateral in chunks) and liquidation thresholds to mitigate this. Inefficient liquidations can result in bad debt for the protocol.

Borrowers can mitigate liquidation risk by:

• Maintaining a high Health Factor (e.g., >2.0) for a safety buffer.
• Using stablecoins as collateral for less volatility.
• Setting up price alerts and monitoring positions.
• Utilizing decentralized insurance or hedging with derivatives. Protocols mitigate systemic risk with circuit breakers, dynamic LTVs, and over-collateralization requirements.

The core protocol component that automatically monitors collateral positions and triggers liquidations. It performs health checks against predefined liquidation thresholds, calculates the liquidation penalty, and auctions the seized collateral. Its design directly impacts market stability and user risk.

A numerical representation of a loan's safety, calculated as (Collateral Value) / (Borrowed Value). When this ratio falls below a protocol's liquidation threshold (e.g., 1.0), the position becomes eligible for auto-liquidation. Users must monitor this metric to avoid involuntary closure of their positions.

Also known as a liquidation bonus, this is the discount applied to a borrower's collateral when it is sold during liquidation. It incentivizes liquidators to participate by allowing them to purchase assets below market price. The penalty is a cost borne by the borrower whose position is closed.

A bot or user that executes liquidation transactions. They provide a crucial service by repaying a portion of a borrower's debt in exchange for discounted collateral, thereby restoring the protocol's solvency. Their activity is essential for clearing underwater positions and maintaining system health.

The maximum percentage of a collateral asset's value that can be borrowed against. For example, an LTV of 75% on ETH means you can borrow up to $0.75 for every $1 of ETH deposited. The liquidation threshold is set higher than the maximum LTV to create a safety buffer.

A traditional finance concept analogous to a low Health Factor. It's a demand from a lender for a borrower to add more collateral to a leveraged position. In DeFi, this process is fully automated via the liquidation engine, removing the need for manual intervention.