Forced Liquidation

A forced liquidation is triggered when a user's Health Factor or Collateral Ratio falls below a protocol's Liquidation Threshold. This typically occurs when:

• The value of the supplied collateral decreases.
• The value of the borrowed asset increases.
• The user's loan-to-value (LTV) ratio exceeds the maximum allowed limit.

Protocols like Aave and Compound continuously monitor these metrics on-chain.

Once triggered, the process is automated and permissionless. A liquidator (often a bot) repays part or all of the undercollateralized debt. In return, they receive the borrower's collateral at a discounted rate, known as the liquidation bonus or penalty. This discount incentivizes liquidators to act quickly, ensuring bad debt is cleared and the protocol remains solvent. The specific mechanics (e.g., fixed discount, Dutch auctions) vary by protocol.

Protocols define liquidation rules through several configurable parameters:

• Loan-to-Value (LTV) Ratio: The maximum borrowing power of collateral.
• Liquidation Threshold: The LTV level at which liquidation becomes possible.
• Liquidation Bonus: The discount liquidators receive on seized collateral (e.g., 5-10%).
• Close Factor: The maximum percentage of a position that can be liquidated in a single transaction.

These parameters are asset-specific and set by governance.

Different DeFi protocols employ distinct liquidation mechanisms:

• Fixed Spread (Aave, Compound): Liquidators buy collateral at a fixed discount.
• Dutch Auction (MakerDAO): Collateral price starts at a premium and decreases over time until a liquidator accepts.
• Pool-based (Synthetix): A designated pool (e.g., sUSD) is used to cover debt, with stakers bearing the risk.

Each design balances speed, capital efficiency, and market impact.

Forced liquidation poses significant risks:

• For the Borrower: Sudden, complete loss of collateral beyond the owed debt due to discounts and fees.
• For the Protocol: Liquidation cascades can occur in volatile markets, where mass liquidations drive collateral prices down further, triggering more liquidations and potentially creating systemic bad debt.
• Slippage: Large liquidations can cause high slippage on DEXs, worsening the borrower's outcome.

Users and protocols employ tools to manage liquidation risk:

• Health Factor Monitors: Wallets and dashboards (like DeBank) provide real-time alerts.
• Safety Buffers: Borrowing well below the maximum LTV to account for price volatility.
• Automated Repayment Bots: Services that automatically add collateral or repay debt to avoid liquidation.
• Protocol-Level Upgrades: Features like Isolated Markets (Aave V3) or Soft Liquidations to reduce systemic risk.

A forced liquidation is triggered when a borrower's Health Factor (or Collateralization Ratio) falls below the protocol's minimum safe threshold, typically 1.0. This occurs when:

• The value of the borrowed asset increases relative to the collateral.
• The value of the collateral asset decreases.
• The borrower's debt is increased by accrued interest. The liquidation threshold is a specific percentage set per asset (e.g., 80% for ETH) that determines when a position becomes eligible for liquidation.

When triggered, a portion of the borrower's collateral is seized and sold, often via a liquidation auction or directly to a liquidation bot. The process includes a liquidation penalty (or bonus) paid to the liquidator, incentivizing them to repay the debt. For example, a 10% penalty means a liquidator can repay $100 of debt to claim $110 worth of collateral. This penalty is a direct loss for the borrower and ensures the protocol remains solvent.

A major systemic risk is a liquidation cascade or death spiral. This occurs when:

• Large, correlated positions are liquidated simultaneously during market volatility.
• The forced selling of collateral drives its market price down further.
• This triggers more liquidations in a self-reinforcing cycle, potentially leading to insolvency if liquidators cannot keep up or if liquidity dries up.

Borrowers face a trade-off between capital efficiency and liquidation risk. A higher Loan-to-Value (LTV) ratio allows more borrowing power but brings the position closer to the liquidation threshold. Strategies to mitigate risk include:

• Using stablecoins as collateral for borrowing volatile assets.
• Actively monitoring health factors and maintaining a significant buffer.
• Utilizing decentralized price oracles to ensure accurate, manipulation-resistant pricing.

Forced liquidations rely on price oracles. A critical attack vector is oracle manipulation, where an attacker artificially inflates or deflates an asset's price on a DEX to trigger unfair liquidations. Protocols mitigate this by using time-weighted average prices (TWAPs) from multiple sources or decentralized oracle networks like Chainlink to resist short-term price spikes.

Liquidations create a competitive landscape for Maximal Extractable Value (MEV). Liquidation bots monitor the mempool and blockchain state, racing to be the first to execute profitable liquidations. This can lead to high gas wars, increasing network congestion and costs. The design of the liquidation mechanism (e.g., Dutch auctions vs. fixed discounts) directly impacts the efficiency and fairness of this process.