Liquidation Ratio

The liquidation ratio (also called the collateral factor or loan-to-value (LTV) ratio threshold) is a predefined percentage set by a lending protocol. It defines the maximum permissible debt a user can take against their deposited collateral. For example, if a vault has a 150% liquidation ratio for ETH, a user who deposits $10,000 worth of ETH can borrow up to a maximum of approximately $6,666 (i.e., $10,000 / 1.5). If the value of their collateral falls or their debt rises, pushing the actual collateralization ratio below this 150% threshold, the position becomes eligible for liquidation.

This mechanism protects the protocol and its lenders from bad debt. When a position's health factor deteriorates below the liquidation ratio, it is flagged as undercollateralized. At this point, liquidators—third-party bots or users—are incentivized to repay a portion or all of the outstanding debt in exchange for seizing the collateral at a discount. This liquidation penalty, often 5-15%, ensures the loan is made whole while compensating the liquidator for their service, maintaining the overall solvency of the lending pool.

The ratio is not static; it is carefully calibrated by protocol governance based on the volatility and liquidity of the underlying collateral asset. Stablecoins like DAI or USDC typically have higher LTV ratios (e.g., 75-85%) because their price is relatively stable. More volatile assets like cryptocurrencies have much lower, more conservative ratios (e.g., 50-65%) to provide a larger safety buffer against rapid price swings. Users must actively monitor their positions, as market downturns can quickly trigger liquidations across many accounts simultaneously.

Understanding and managing your position relative to the liquidation ratio is fundamental to DeFi borrowing. Tools like health factors or safety scores give users a real-time view of their margin. A health factor above 1.0 (or 100%) indicates a safe position; as it approaches the liquidation threshold of 1.0, the risk increases exponentially. Proactive users can add more collateral or repay debt to improve their ratio and avoid the costly liquidation process, which results in loss of assets and payment of fees.

The liquidation ratio (also called the liquidation threshold or collateral factor) is the minimum ratio of a position's collateral value to its borrowed value that must be maintained to avoid liquidation. It is expressed as a percentage (e.g., 150%). If the collateralization ratio of a user's loan falls below this predefined threshold—typically due to a drop in collateral value or a rise in debt value—the position becomes eligible for liquidation by network participants. This mechanism protects lenders by ensuring loans remain overcollateralized, mitigating the protocol's insolvency risk.

This ratio is set by governance or protocol developers and varies by collateral asset type, reflecting its perceived risk and volatility. For example, a stablecoin like DAI might have a liquidation ratio of 110%, while a more volatile asset like ETH might be set at 150%. The health factor or collateral ratio is a real-time metric calculated as (Collateral Value * Liquidation Ratio) / Borrowed Value. When this factor drops below 1, the position is undercollateralized. Protocols like MakerDAO, Aave, and Compound use this core mechanism to manage systemic risk within their lending markets.

The actual liquidation process is triggered automatically by smart contracts and executed by keepers or liquidators. These actors repay a portion of the undercollateralized debt in exchange for the discounted collateral, charging a liquidation penalty (or bonus) to the borrower. This penalty, often 5-15%, is designed to incentivize liquidators while punishing risky positions. The process reduces the protocol's exposure and restores the health of the loan book, but it can result in significant loss for the borrower if market conditions move rapidly against their position.

The liquidation ratio (or collateralization ratio) is the primary metric for assessing liquidation risk. It is calculated by dividing the total value of a user's supplied collateral by the total value of their borrowed assets, expressed as a percentage. A position becomes undercollateralized and subject to liquidation when this ratio falls below the protocol's liquidation threshold, a predefined minimum level set to protect the solvency of the lending pool. Monitoring this ratio in real-time is crucial for borrowers.

Several dynamic factors cause the liquidation ratio to fluctuate, directly impacting risk. The most significant are asset price volatility—if the value of collateral assets falls or borrowed assets rise, the ratio decreases—and interest accrual on the debt, which steadily increases the borrowed value over time. Borrowers must account for these variables and maintain a health factor or collateral factor (protocol-specific terms for this safety buffer) significantly above the liquidation threshold to absorb market swings.

To mitigate risk, users employ strategies like over-collateralization, using stable assets as collateral, and setting up automated alerts or liquidation protection bots. For example, a position with $10,000 in ETH collateral and a $5,000 USDC loan has a 200% collateralization ratio. If the protocol's liquidation threshold is 150%, the ETH price can only drop roughly 25% before the position becomes eligible for liquidation, highlighting the importance of the initial safety margin.

From the protocol's perspective, the liquidation mechanism is a critical risk management tool. When triggered, it allows liquidators—third-party actors—to repay a portion of the undercollateralized debt in exchange for the borrower's collateral at a discounted price, known as the liquidation penalty. This process ensures the loan is recapitalized and the protocol remains solvent, but it results in a net loss for the borrower, making proactive risk calculation essential.