Close Factor

The Close Factor is a critical risk management parameter in decentralized finance (DeFi) lending and borrowing protocols like Compound and Aave. It acts as a circuit breaker during the liquidation process, which is triggered when a borrower's health factor or collateral factor falls below a safe threshold. Instead of allowing a liquidator to seize all of a borrower's collateral at once, the Close Factor limits the liquidation to a specific percentage (e.g., 50%). This mechanism protects borrowers from total loss in volatile markets and prevents market instability from large, sudden liquidations.

For example, if a protocol's Close Factor is set to 0.5 (or 50%) and a borrower has $10,000 in collateral backing an undercollateralized loan, a liquidator can only repay up to 50% of the outstanding debt in a single transaction, seizing a proportional amount of collateral. The borrower's position remains open but must be restored to health. If it remains unhealthy, subsequent liquidations can occur. This parameter is typically governed by the protocol's decentralized autonomous organization (DAO), which can adjust it based on market conditions to balance system safety with efficiency.

The Close Factor works in conjunction with the liquidation incentive or liquidation bonus, which is the discount liquidators receive on the seized collateral as a reward for providing liquidity and resolving bad debt. A lower Close Factor (e.g., 25%) results in more gradual, partial liquidations, which can be less disruptive but may prolong market risk. A higher factor allows for faster resolution of insolvent positions. Understanding this mechanism is essential for both borrowers assessing their liquidation risk and for liquidators calculating potential profit opportunities within the protocol's defined rules.

The close factor is a protocol-level parameter, expressed as a percentage, that determines the maximum portion of a borrower's debt that can be repaid in a single liquidation event. When a loan's health factor falls below 1 (becoming undercollateralized), liquidators are incentivized to repay a portion of the debt in exchange for the borrower's collateral at a discounted price. The close factor acts as a circuit breaker, preventing the entire position from being liquidated at once, which helps mitigate market volatility and reduces the risk of cascading liquidations across the protocol.

For example, if a protocol sets its close factor to 50%, and a borrower has an undercollateralized debt of 100 ETH, a liquidator can repay up to 50 ETH of that debt in a single transaction. In return, the liquidator receives a corresponding amount of the borrower's collateral, valued at a liquidation bonus (or penalty) that is greater than the debt repaid. This mechanism ensures liquidations are distributed, allowing the borrower a chance to rectify their position by adding more collateral or repaying debt before the remainder of their loan becomes eligible for liquidation again.

Protocols like Aave and Compound implement close factors, typically ranging from 25% to 50%. The exact value is governed by the protocol's decentralized autonomous organization (DAO), which can adjust it based on market conditions and risk assessments. A lower close factor increases the number of partial liquidations required to close a position, potentially reducing immediate selling pressure on the collateral asset. This parameter works in conjunction with the liquidation threshold and health factor to form a comprehensive risk management framework for overcollateralized lending.

The Close Factor and Liquidation Incentive are two distinct but interdependent protocol parameters that define the scope and reward for liquidators. The Close Factor is a percentage (e.g., 50%) that determines the maximum portion of a borrower's undercollateralized debt a liquidator can repay in a single transaction. The Liquidation Incentive is a bonus percentage (e.g., 5-10%) added to the collateral seized, which serves as the liquidator's profit. Critically, the incentive is applied only to the collateral corresponding to the debt amount actually repaid, which is capped by the Close Factor.

This interaction creates a bounded economic model. For example, if a borrower has a $100 debt position that becomes eligible for liquidation, and the protocol has a Close Factor of 50% and a Liquidation Incentive of 8%, a liquidator can repay up to $50 of the debt. In return, they can seize the collateral backing that $50, plus an 8% bonus, receiving collateral worth $54. This design prevents a single liquidation from wiping out a borrower's entire position at once (protecting them from extreme volatility) while ensuring liquidators are compensated for their work and risk.

Protocols tune these parameters to balance market stability with liquidation efficiency. A low Close Factor with a high Liquidation Incentive encourages frequent, partial liquidations, which can be less disruptive. Conversely, a high Close Factor with a modest incentive may lead to fewer but larger liquidation events. The parameters are often expressed in basis points (e.g., a 5000 basis point Close Factor equals 50%) and are typically set by governance. Understanding their interaction is essential for analyzing protocol risk, designing keeper bots, and assessing borrower vulnerability during market downturns.