Liquidation Threshold

The liquidation threshold is a protocol-set percentage (e.g., 80%) applied to a specific collateral asset. It defines the maximum Loan-to-Value (LTV) ratio at which a position remains safe. For example, with ETH as collateral at an 80% threshold, a user can borrow up to $800 against $1000 of ETH before risking liquidation. This parameter is distinct from the maximum LTV, which is the initial borrowing limit.

The liquidation threshold directly calculates a position's Health Factor (HF). The formula is typically: HF = (Collateral Value * Liquidation Threshold) / Borrowed Value. When the HF falls below 1.0, the collateral value relative to the debt has breached the safety threshold, triggering the position for liquidation. This acts as an automated, on-chain risk monitor.

Protocols assign different liquidation thresholds based on each collateral asset's volatility and liquidity. For instance:

• Stablecoins (USDC, DAI): High threshold (~85-90%) due to low volatility.
• Major Cryptos (ETH, WBTC): Moderate threshold (~75-85%).
• Altcoins or LP tokens: Lower threshold (~50-65%) due to higher risk. This tiered system manages the protocol's overall risk exposure.

Once the Health Factor drops below 1, the position is flagged. Liquidators (bots or users) can then repay a portion of the undercollateralized debt in exchange for seizing the borrower's collateral at a liquidation bonus (discount). This process closes the risky debt, protects the protocol from bad debt, and incentivizes market participants to maintain system solvency.

These two parameters work in tandem to define borrowing limits and safety buffers.

• Maximum LTV: The initial borrowing limit (e.g., 75% for ETH). You cannot borrow above this.
• Liquidation Threshold: The higher value (e.g., 82% for ETH) that triggers liquidation. The difference between these values creates a safety buffer (e.g., 7%), allowing for some price fluctuation before liquidation occurs.

Different DeFi protocols implement this concept with varying terminology and mechanics.

• Aave & Compound: Use explicit Liquidation Threshold and Liquidation Bonus parameters.
• MakerDAO: Uses the Liquidation Ratio, which is conceptually similar but expressed inversely (e.g., a 150% ratio means collateral must be worth 1.5x the debt). Understanding these specific implementations is crucial for risk management.

This highlights the evolution of threshold mechanics:

• v2 (Traditional): A single, global Collateral Factor for each asset applied to all borrowing. Liquidation occurs when borrows * Liquidation Threshold > collateral.
• v3 (Isolated): Introduces Collateral Caps and Borrow Caps. The Liquidation Threshold is applied specifically to designated collateral for a particular borrow asset, allowing for more precise, asset-specific risk management and capital efficiency.

The Liquidation Threshold is the maximum Loan-to-Value (LTV) ratio at which a borrowing position can remain before it becomes eligible for liquidation. It is set as a percentage of the collateral's value. For example, if ETH has an 80% threshold, a position is liquidatable when the debt value reaches 80% of the collateral's value. This buffer between the initial Maximum LTV (e.g., 75%) and the Liquidation Threshold (e.g., 80%) provides a safety margin for the protocol.

A position's Health Factor determines its proximity to liquidation, calculated as (Collateral Value * Liquidation Threshold) / Borrowed Value. When this factor falls below 1.0, the position is undercollateralized and can be liquidated. Key dynamics include:

• Price Volatility: Rapid asset price drops can push the Health Factor below 1.0 almost instantly.
• Interest Accrual: Borrowing variable-rate assets increases the debt over time, gradually lowering the Health Factor.
• Protocol Parameters: Governance can adjust thresholds, changing the risk profile of existing positions.

When triggered, a liquidation allows a third party (a liquidator) to repay part of the unhealthy debt in exchange for a discounted portion of the collateral. This involves:

• Liquidation Bonus: The discount offered to liquidators (e.g., 5-10%) as an incentive, which is a direct penalty to the borrower.
• Partial vs. Full: Protocols often liquidate only enough to restore the Health Factor above 1.0, not the entire position.
• Gas Wars: In volatile markets, liquidators compete via transaction fees, which can increase the net cost for the borrower.

To avoid liquidation, borrowers must actively monitor and manage their positions. Critical strategies include:

• Conservative Borrowing: Borrowing well below the Maximum LTV provides a larger safety cushion against market swings.
• Monitoring Tools: Using dashboards and price alerts to track Health Factors in real-time.
• Collateral Management: Adding more collateral or repaying debt to improve the Health Factor proactively.
• Understanding Assets: Knowing the specific Liquidation Thresholds for each collateral type, as riskier assets have lower thresholds.

For the lending protocol, the Liquidation Threshold is a key lever for managing systemic risk. Setting it too high increases borrower risk of liquidation; setting it too low risks insolvency if collateral value falls faster than liquidations can occur. This parameter is often determined by:

• Collateral Volatility: Stablecoins have higher thresholds (e.g., 85%) than volatile assets like crypto (e.g., 65%).
• Liquidity Depth: Assets with deep markets can support higher thresholds due to easier liquidation.
• Governance: Changes are typically proposed and voted on by token holders, introducing governance risk.

Understanding the Liquidation Threshold requires familiarity with interconnected DeFi mechanics:

• Loan-to-Value (LTV) Ratio: The ratio of borrowed amount to collateral value.
• Maximum LTV: The highest LTV at which a new loan can be taken, always lower than the Liquidation Threshold.
• Liquidation Bonus: The incentive paid to liquidators from the seized collateral.
• Oracle Price Feeds: The external data sources that determine collateral value; latency or manipulation can trigger false liquidations.
• Close Factor: The maximum percentage of a position that can be liquidated in a single transaction.

The Loan-to-Value (LTV) ratio is the initial risk parameter set when a loan is opened, representing the maximum amount that can be borrowed against a specific collateral asset. It is expressed as a percentage (e.g., 75% LTV for ETH).

• Key Difference: LTV is the borrowing limit at opening, while the Liquidation Threshold is the safety limit that triggers a forced closure.
• Safety Buffer: The gap between the LTV and the Liquidation Threshold is the "safety margin" or "liquidation buffer" that protects the protocol from price volatility.

A Health Factor is a dynamic, user-specific metric that quantifies the safety of a borrowed position. It is calculated as the ratio of the collateral value (adjusted by its liquidation threshold) to the total borrowed value.

• Formula: Health Factor = (Σ Collateral Value * Liquidation Threshold) / Total Borrowed Value
• Liquidation Trigger: When the Health Factor falls below 1.0, the position becomes undercollateralized and is eligible for liquidation. The Liquidation Threshold is the key parameter in this calculation.

The Liquidation Bonus (or incentive) is a discount offered to liquidators when they repay a user's debt and seize their collateral. It compensates liquidators for their work and market risk.

• Mechanism: A position is liquidated at a price better than the market price for the liquidator (e.g., a 5% bonus means they buy collateral at 95% of its value).
• Purpose: This bonus ensures there is always economic incentive to liquidate unhealthy positions, protecting the protocol's solvency. It is a separate parameter from the Liquidation Threshold.

Maximum LTV is the highest Loan-to-Value ratio allowed for a specific collateral asset within a lending protocol. It is a global, asset-level parameter set by governance or risk teams.

• Protocol Safety: It defines the absolute upper limit for borrowing against an asset, establishing the initial risk profile.
• Relationship to Threshold: The Liquidation Threshold is always set higher than the Maximum LTV. This creates the necessary buffer (e.g., Max LTV 80%, Liquidation Threshold 85%) to prevent immediate liquidations after borrowing.

Collateral Factor is a term synonymous with Liquidation Threshold, used primarily in protocols like Compound Finance. It represents the percentage of a collateral asset's value that can be borrowed against before liquidation risk occurs.

• Identical Function: A Collateral Factor of 75% means that if the borrowed value exceeds 75% of the collateral's value, the position can be liquidated.
• Usage: While "Liquidation Threshold" is more descriptive of the trigger point, "Collateral Factor" is the historical term used in many smart contract codebases and documentation.

The Close Factor is a protocol parameter that limits how much of an unhealthy position can be liquidated in a single transaction. It is a risk mitigation tool to prevent overly large, market-disrupting liquidations.

• Function: If the Close Factor is 50%, a liquidator can only repay up to 50% of the outstanding debt in one go, even if the Health Factor is far below 1.0.
• System Design: This works in tandem with the Liquidation Threshold and Liquidation Bonus to create a controlled, staggered liquidation process that protects both the protocol and the borrower.