Liquidation Threshold

The Liquidation Threshold is the maximum Loan-to-Value (LTV) ratio at which a position remains safe. If the Health Factor (a derived metric) falls below 1.0, the position is undercollateralized and can be liquidated. For example, with a 75% threshold, a $100 ETH collateral can safely back a $75 loan; if ETH's value drops, pushing the loan value above $75, the position is at risk.

Protocols set unique thresholds for each collateral asset based on its volatility and liquidity.

• Stablecoins (e.g., USDC): Often have high thresholds (~80-90%) due to price stability.
• Volatile assets (e.g., ETH): Have lower thresholds (~70-80%) to buffer against swings.
• Exotic/Low-liquidity assets: Have the lowest thresholds (e.g., 50% or less). This tiered system manages systemic risk.

Two distinct but related parameters govern borrowing:

• Loan-to-Value (LTV) Ratio: The maximum you can initially borrow (e.g., 70% of collateral).
• Liquidation Threshold: The higher LTV level that triggers liquidation (e.g., 80%). The gap between them creates a safety buffer. A position enters the 'danger zone' when its LTV exceeds the maximum but is below the threshold, giving users time to add collateral or repay debt.

Different protocols implement the threshold with specific mechanics:

• Aave: Uses a Health Factor calculated as (Collateral Value * Liquidation Threshold) / Total Borrowed. Liquidation occurs when HF < 1.
• Compound: Uses a Collateral Factor (similar to LTV) for borrowing and a separate Liquidation Incentive that determines the discount liquidators receive.
• MakerDAO: Employs a Liquidation Ratio for each Vault type, which functions as the threshold.

When a position is liquidatable, a liquidation penalty (e.g., 5-15%) is applied to the debt. Liquidators repay part of the debt in exchange for the undervalued collateral at a discount. This penalty ensures the protocol remains overcollateralized after the event and incentivizes third-party keepers to maintain system solvency.

Thresholds are not static. Decentralized Autonomous Organizations (DAOs) or protocol governance can vote to adjust them in response to:

• Market volatility shifts.
• New oracle security assessments.
• Changes in asset liquidity depth. This allows protocols to dynamically manage risk exposure across their entire portfolio of supported assets.

Protocols balance safety and capital efficiency differently via this parameter:

• Conservative Thresholds (e.g., MakerDAO's 145% ratio) prioritize system solvency.
• Aggressive Thresholds (e.g., high LLTV in isolated markets) maximize borrowing power.
• Dynamic Adjustments: Some protocols (via governance) can change thresholds based on market volatility.
• Liquidation Incentive: The mechanism (bonus, penalty, reserve) varies, affecting liquidator economics and user cost.

The liquidation threshold is the collateral value ratio (e.g., 80%) at which a user's borrowing position becomes under-collateralized and eligible for liquidation by third-party liquidators. It is distinct from the Loan-to-Value (LTV) ratio, which governs initial borrowing capacity. The buffer between the LTV and the liquidation threshold provides a safety margin before liquidation risk is triggered.

A position's Health Factor (HF) is the primary metric for liquidation risk, calculated as (Collateral Value * Liquidation Threshold) / Borrowed Value. When HF ≤ 1, the position is at the liquidation threshold and can be liquidated. Users must monitor HF and understand that volatile asset prices can cause it to drop rapidly, crossing the threshold unexpectedly.

• Example: With $100 ETH collateral (threshold: 80%) and $60 DAI debt, HF = (100 * 0.8) / 60 = 1.33. If ETH drops to $90, HF becomes (90 * 0.8) / 60 = 1.2, moving closer to the liquidation threshold of 1.0.

Liquidation thresholds are not standardized and vary significantly by protocol and asset. Riskier or more volatile assets (e.g., altcoins) typically have lower thresholds (e.g., 65%) than blue-chip assets (e.g., ETH, BTC) which may have thresholds of 80-85%. This reflects the asset's price stability and liquidity. Users must check the specific parameters for each collateral asset in the protocol's documentation, as using multiple asset types in a single position creates a composite risk profile.

Once the liquidation threshold is breached, a liquidation incentive (or bonus) is offered to liquidators, who repay a portion of the debt in exchange for seized collateral at a discounted rate. This process incurs a liquidation penalty for the borrower, which is a fee added to their debt, further eroding their remaining collateral. The typical sequence is:

• Position HF falls to ≤ 1.
• Liquidator repays some debt.
• Liquidator receives collateral worth more than the debt repaid.
• Borrower's debt is reduced but incurs a penalty fee.

To avoid hitting the liquidation threshold, borrowers should:

• Maintain a high Health Factor (e.g., > 2.0) to create a large buffer against market swings.
• Use less volatile assets as primary collateral.
• Monitor positions actively or use automated tools for alerts.
• Provide additional collateral or repay debt proactively if the market turns volatile.
• Understand that liquidation can be partial, not necessarily closing the entire position, but it always results in a net loss for the borrower.

Liquidation thresholds are enforced based on oracle prices. Therefore, the integrity of the price feed is paramount. Risks include:

• Oracle latency or failure: Stale prices may cause delayed or incorrect liquidations.
• Oracle manipulation: An attacker could artificially lower an asset's price on one exchange to trigger liquidations on-chain, profiting from the discounts (a flash loan attack vector).
• Protocols mitigate this using time-weighted average prices (TWAPs) or multiple oracle sources, but the risk of a price discrepancy triggering liquidation remains a systemic consideration.

The liquidation bonus (or discount) is an incentive paid to liquidators. It is a percentage added to the value of the collateral they seize, allowing them to purchase it below market price. This bonus is necessary because liquidators take on execution risk (gas, slippage). For instance, a 5% bonus on ETH means a liquidator repaying $100 of debt can seize $105 worth of ETH, profiting from the difference.

The close factor is a protocol parameter that limits how much of an underwater position a single liquidation transaction can resolve. It is expressed as a percentage of the borrowed amount. For example, a 50% close factor means a liquidator can only repay up to half of the outstanding debt in one transaction. This mechanism prevents a single liquidator from taking a large, discounted position all at once, promoting market stability and fairness.

Maximum Loan-to-Value is often used interchangeably with the initial LTV ratio. It is the strict upper limit for borrowing when opening a position. The liquidation threshold is always set higher than the Maximum LTV. This creates a 'buffer zone' or 'liquidation range' (e.g., between 80% Max LTV and 85% Liquidation Threshold) where borrowing is not allowed, but existing positions are not yet liquidated, giving users time to react.