Liquidation MEV

A liquidation is triggered when a user's health factor or collateralization ratio falls below a protocol-defined threshold (e.g., 1.0). This creates a time-sensitive opportunity for searchers to repay the borrower's debt in exchange for their collateral at a liquidation discount (e.g., 5-10%). The first valid transaction to execute this wins the right to the discounted collateral.

Searchers run sophisticated bots that monitor the memepool and on-chain state for undercollateralized positions. Their goal is to construct and broadcast the winning transaction bundle. This involves:

• Gas bidding: Outbidding competitors with higher gas prices.
• Bundle building: Packaging the liquidation with other arbitrage or sandwich trades to maximize profit.
• Frontrunning: Ensuring their transaction is ordered first in the block, often by paying block builders directly via MEV auctions.

Protocols offer a liquidation incentive (or bonus) to ensure liquidations occur promptly, protecting the solvency of the lending pool. This is typically a percentage discount on the collateral's market value. For example, a 5% discount on $100,000 of ETH collateral provides a $5,000 instant profit opportunity for the liquidator, minus gas costs. This discount is the primary economic driver for liquidation MEV.

Most liquidation MEV is captured through private channels with block builders. Searchers submit transaction bundles with bids to specialized builders (e.g., via Flashbots Protect or private RPC endpoints) rather than the public memepool. This private order flow prevents frontrunning by other searchers and ensures their bundle is included in the next block, making the process more efficient and predictable.

Liquidations often create price dislocations. A sophisticated searcher might combine the liquidation with a DEX arbitrage trade. For example, after acquiring discounted collateral (e.g., wBTC), they immediately swap it on a decentralized exchange to capture the difference between the discounted price and the market price, amplifying their MEV profit.

Protocols must carefully calibrate their liquidation parameters (threshold, discount, penalty). A discount that is too low may not incentivize liquidators, risking protocol insolvency. A discount that is too high can be excessively punitive to borrowers and create outsized, volatile MEV rewards. Some newer designs use Dutch auctions or keeper networks to distribute liquidation rights more fairly.

Liquidation MEV occurs when a searcher identifies a loan that has fallen below its required collateralization ratio on a protocol like Aave or Compound. The searcher pays a portion of the outstanding debt to trigger the liquidation, receiving a liquidation bonus (or penalty) in the form of discounted collateral. The profit is the difference between the debt repaid and the market value of the collateral seized.

Searchers run specialized bots that monitor the blockchain for liquidatable positions. Their primary tasks are:

• Monitoring: Constantly scanning mempools and state for unsafe loans.
• Bundling: Creating a transaction bundle that includes the liquidation call.
• Auction Bidding: On protocols with Dutch auctions (e.g., MakerDAO), bidding optimally for the collateral.
• Frontrunning: Protecting their profitable transaction from being copied by other searchers, often using private transaction relays.

Protocols design liquidation mechanisms to balance system safety with searcher competition. Key parameters include:

• Liquidation Bonus: The discount offered to liquidators (e.g., 5-10%).
• Close Factor: The maximum portion of a debt that can be liquidated in one transaction.
• Auction Models: Fixed discount (Aave) vs. descending price auctions (Maker). These settings directly influence the liquidation efficiency and the size of the MEV opportunity, ensuring bad debt is cleared quickly.

Liquidation MEV has complex effects on the DeFi ecosystem:

• Positive: Provides essential liquidity for risk management, protecting protocols and depositors from insolvency.
• Negative: Can lead to negative externalities like network congestion and high gas fees during market volatility.
• Centralization Pressure: The capital and technical requirements for successful MEV extraction can favor large, sophisticated players.

Liquidation MEV often interacts with or enables other forms of Maximal Extractable Value:

• Sandwich Attacks: A liquidator's large collateral sale can be targeted by frontrunning bots.
• Arbitrage: Liquidations create large, imbalanced trades that arbs can profit from.
• Jito-Style Tips: On Solana, searchers pay priority fees (tips) to validators to ensure their liquidation transactions are included.

Liquidation MEV occurs when a borrower's collateral value falls below the required health factor or collateralization ratio. Searchers run bots to monitor the mempool for these undercollateralized positions. The primary extraction methods are:

• Front-running: Bidding higher gas fees to execute the liquidation before the original, protocol-submitted transaction.
• Sandwiching: Placing transactions before and after the liquidation to profit from the resulting price impact on the collateral asset.
• Back-running: Executing immediately after a liquidation to capture arbitrage opportunities from the forced sale.

This competition has a direct cost for the liquidated user. Key consequences include:

• Liquidation Penalty: The borrower pays a fixed penalty (e.g., 5-15%) to the liquidator, which is the primary source of MEV profit.
• Worse Execution: Searchers may split large positions into smaller trades across different venues to maximize profit, leading to greater slippage and a lower recovery price for the collateral. This leaves the borrower with more debt to repay.
• Gas Auction Costs: The "gas war" to win the liquidation increases network congestion and fees for all users.

Protocols implement mechanisms to manage liquidation MEV and protect users:

• Dutch Auctions: Instead of a fixed penalty, the discount on collateral starts high and decreases over time (e.g., Euler, Maker's Collateral Auction Module). This reduces the incentive for frantic gas bidding.
• Keeper Systems: Using permissioned or incentivized keepers (e.g., Aave's Guardian) to submit liquidation transactions, though this can centralize the opportunity.
• MEV-Capturing Design: Some protocols, like Compound, direct a portion of the liquidation penalty to a community treasury, attempting to recapture some MEV value.

Liquidation MEV is a major subset of the broader Maximal Extractable Value (MEV) landscape. It is distinct from other forms like:

• DEX Arbitrage: Profiting from price differences across decentralized exchanges.
• NFT MEV: Front-running NFT mints or profitable trades.
• Long-tail MEV: Exploiting obscure opportunities in smaller protocols. Liquidation MEV is often considered more "justified" or "necessary" MEV, as it provides the essential service of maintaining protocol solvency, albeit profitably.

Extracting liquidation MEV requires sophisticated infrastructure, creating a high barrier to entry:

• Mempool Monitoring: Real-time scanning of pending transactions for undercollateralized accounts.
• Fast RPC Endpoints: Low-latency connections to nodes to receive transaction data quickly.
• Flash Bots & Private RPCs: Using services like Flashbots Protect to submit transaction bundles directly to validators, avoiding the public mempool and preventing front-running from other searchers.
• Simulation Engines: Rapidly simulating transaction outcomes to ensure profitability before submission.

Validators (or block producers) are the ultimate arbiters of liquidation MEV. They decide which transactions are included in a block and in what order.

• Ordering Power: Validators can reorder transactions within a block to capture MEV for themselves (proposer-builder separation (PBS) aims to mitigate this).
• Bundle Auctions: Through MEV-Boost, validators outsource block building to specialized builders who compete by offering bids (including profits from liquidation bundles) for the right to build the block.
• Economic Incentive: MEV revenue from liquidations can significantly supplement a validator's staking rewards, influencing network security dynamics.