Liquidator

A liquidator's primary function is to repay a borrower's debt in exchange for their collateral assets at a discount. This process, known as a liquidation, is triggered when a loan's collateralization ratio falls below a protocol's liquidation threshold. The liquidator's profit is the difference between the debt repaid and the value of the seized collateral, incentivizing rapid action to protect the protocol.

Liquidators act as a first line of defense against insolvency risk. By promptly closing unhealthy positions, they:

• Prevent bad debt from accumulating on the protocol's balance sheet.
• Maintain the peg of synthetic assets or stablecoins (e.g., in CDP systems like MakerDAO).
• Ensure that all remaining loans are sufficiently collateralized, protecting lenders' funds. Without active liquidators, a market crash could render a protocol insolvent.

Protocols carefully design liquidation incentives to balance efficiency with fairness.

• Liquidation Penalty / Bonus: A discount (e.g., 5-15%) on the collateral's market value, set by governance.
• Liquidation Fee: A portion of the penalty may be directed to a protocol treasury or insurance fund.
• Gas Cost Considerations: Incentives must exceed network transaction costs to make liquidation economically viable for bots and users.

Different protocols implement distinct liquidation mechanisms:

• Direct Liquidation (Aave, Compound): Liquidators repay debt directly to the protocol and receive a fixed percentage of the collateral.
• Dutch Auction (MakerDAO): Collateral is sold via a decreasing-price auction (Collateral Auction) to maximize recovery.
• Pool-based Liquidation: Unhealthy positions are absorbed into a shared pool for gradual settlement. The method impacts market impact and liquidator competition.

Due to the time-sensitive and profitable nature of liquidations, they are predominantly executed by automated liquidation bots. This creates a competitive environment that intersects with Maximal Extractable Value (MEV).

• Bots monitor the mempool and blockchain state for liquidation opportunities.
• They engage in priority gas auctions (PGAs) to have their transaction processed first.
• This competition generally benefits protocol health but can lead to high network congestion and costs.

For borrowers, liquidation is a significant risk event.

• Health Factor / Collateral Ratio: Users must monitor this metric closely.
• Liquidation Close Factor: Protocols may only allow a portion of a position to be liquidated at once.
• Slippage & Bad Debt: In volatile markets, collateral may be sold for less than the debt, potentially creating bad debt if auction mechanisms fail.
• Oracle Manipulation: Attacks on price oracles can trigger false liquidations.

The process of forcibly closing a borrower's position when its collateral value falls below the required collateralization ratio. The liquidator repays the outstanding debt and receives the collateral at a discount as a reward, ensuring the protocol remains solvent.

• Trigger: A price drop causes the health factor or collateral ratio to breach a threshold.
• Outcome: The position is closed, debt is cleared, and the liquidator profits from the liquidation bonus.

A numerical metric used by lending protocols like Aave to determine the risk level of a borrowing position. It represents the ratio of the position's collateral value to its borrowed value.

• Formula: Health Factor = (Collateral Value * Liquidation Threshold) / Borrowed Value
• Liquidation Trigger: When the Health Factor drops below 1.0, the position becomes eligible for liquidation to protect the protocol from bad debt.

The incentive paid to a liquidator for executing a liquidation. It is a percentage discount on the market value of the seized collateral.

• Purpose: Compensates the liquidator for risk and transaction costs, ensuring liquidations occur promptly.
• Example: A 10% liquidation bonus means the liquidator can buy $100 worth of collateral for $90 of repaid debt, netting a $10 profit.

A borrowing position where the value of the deposited collateral is insufficient to cover the outstanding loan plus required safety margins. This is the primary condition that triggers liquidation.

• Cause: Typically caused by a sharp decline in the collateral asset's price relative to the borrowed asset.
• Risk: If not liquidated, it creates bad debt for the lending protocol, threatening its financial stability.

The smart contract subsystem within a DeFi protocol that defines the rules and mechanics for liquidations. It is a core component of protocol risk management.

• Functions: Calculates health factors, determines eligible positions, defines the liquidation bonus, and executes the liquidation logic.
• Design: Varies by protocol (e.g., Aave's fixed discount auctions vs. MakerDAO's collateral auctions).

Profit that can be extracted by reordering, including, or censoring transactions within blocks. Liquidations are a primary source of MEV on networks like Ethereum.

• Connection: Liquidators, often MEV bots, compete to be the first to submit a profitable liquidation transaction.
• Impact: This competition can lead to high gas fees and frontrunning, where bots outbid each other to capture the liquidation reward.