Margin Call

A margin call is triggered when the Loan-to-Value (LTV) ratio exceeds the protocol's Maintenance Margin Requirement (MMR). This occurs because the value of the collateral asset has fallen or the borrowed asset's value has risen.

• Formula: (Debt Value / Collateral Value) > MMR
• Example: With $10,000 in ETH as collateral and a $5,000 USDC debt, the LTV is 50%. If the protocol's MMR is 75%, a margin call triggers if ETH's value drops so the LTV exceeds 75%.

If a position is not remedied, it enters liquidation. A liquidator (often a bot) repays part or all of the debt and receives the collateral at a discount as a bounty.

• Key Mechanism: This is an automated, permissionless process to ensure the protocol remains solvent.
• Liquidation Penalty: The discount (e.g., 5-10%) incentivizes liquidators and acts as a fee for the risky position.

To avoid liquidation, a user can take one of two actions to restore their LTV below the MMR:

• Add More Collateral: Depositing additional assets increases the collateral value, lowering the LTV ratio.
• Repay Debt: Partially repaying the loan reduces the debt value, also lowering the LTV.

These actions must be completed before the position's health factor crosses the liquidation threshold.

The Health Factor (HF) is a numerical representation of a position's safety, calculated as (Collateral Value * Liquidation Threshold) / Debt Value.

• HF > 1: Position is safe.
• HF <= 1: Position is undercollateralized and subject to liquidation.

This metric provides a continuous view of risk, with a margin call typically occurring as the HF approaches 1.

While the core logic is consistent, implementations differ:

• Partial vs. Full Liquidation: Some protocols liquidate only enough to restore health; others close the entire position.
• Auction Models: Traditional finance may use auctions; DeFi often uses fixed-discount, instant liquidations.
• Cross-Margin vs. Isolated: In cross-margin, all collateral backs all debts. In isolated margin, risk is contained to a specific pair.

During high volatility, mass margin calls can lead to liquidation cascades. As liquidators sell collateral, its price drops, triggering further liquidations in a negative feedback loop.

• Mitigations: Protocols use circuit breakers, dynamic fees, and oracle safeguards.
• Historical Context: Events like the March 2020 crash and the LUNA collapse demonstrated the severe impact of cascading liquidations.

The primary trigger is a user's Health Factor (HF) falling below the protocol's liquidation threshold (e.g., 1.0). Health Factor is calculated as (Collateral Value * Liquidation Threshold) / Borrowed Value. When HF < 1, the position is eligible for liquidation, initiating a margin call. Protocols like Aave and Compound use this model.

• Example: If ETH collateral drops in value, the numerator decreases, pushing HF down.
• Automated: This check happens continuously via oracles updating asset prices.

A drop in the market price of the collateral asset is the most common economic trigger. Since loan-to-value (LTV) ratios are dynamic, a sharp decline in an asset's price can rapidly degrade the Health Factor.

• Volatility Risk: High-volatility assets (e.g., memecoins) reach liquidation thresholds faster.
• Oracle Price Feed: The trigger uses the oracle's price, not the DEX spot price, though arbitrageurs align them.

If the asset you borrowed increases in value relative to your collateral, your debt becomes larger in collateral terms, worsening your Health Factor. This is a critical risk in cross-margin or multi-asset borrowing.

• Example: Borrowing stablecoins is low-risk; borrowing a volatile asset that pumps can trigger a call.
• Debt Denomination: Your debt is always measured in the base currency (e.g., USD value), so any debt asset appreciation counts.

Governance can change risk parameters, triggering margin calls for existing positions. Key parameters include:

• Liquidation Threshold: Lowering this makes positions riskier instantly.
• Loan-to-Value (LTV) Ratio: Reducing the max LTV for a collateral asset.
• Asset Classification: An asset being marked as "not collateral" forces immediate repayment.

These are non-market triggers that users must monitor via governance proposals.

Once triggered, the protocol opens the position for liquidation. A liquidator (often a bot) repays part or all of the debt in exchange for the collateral at a liquidation bonus (discount).

• Key Mechanics:
  • Liquidation Bonus: Incentive for liquidators (e.g., 5-15%).
  • Close Factor: Maximum percentage of debt that can be liquidated in one transaction.
  • Gas Race: Liquidators compete in a gas auction to seize the opportunity.

Users avoid margin calls by actively managing their Health Factor.

• Common Strategies:
  • Deposit More Collateral: Increases the numerator in the HF formula.
  • Repay Debt: Reduces the denominator in the HF formula.
  • Use Safer Assets: Borrow against high-liquidity, low-volatility collateral (e.g., stETH, wBTC).
  • Monitoring Tools: Use dashboards and alerts to track HF in real-time.

The most direct action to increase your Health Factor or Collateral Ratio. Adding more of the accepted collateral asset to your position increases the total value securing the loan, moving you further from the liquidation threshold.

• Example: On Aave, if your Health Factor drops to 1.1, depositing more ETH can raise it back above the safe threshold of 1.5.
• Impact: Immediately reduces liquidation risk but increases capital commitment and potential loss exposure.

Reducing the borrowed amount lowers the Loan-to-Value (LTV) ratio, directly improving the position's health. This can be done by repaying some of the principal using your own funds or by selling other assets.

• Mechanism: Repaying debt decreases the numerator in the LTV calculation (Debt Value / Collateral Value).
• Strategic Note: Repaying stablecoin debt with a volatile collateral asset is often safer than the reverse, as it avoids selling collateral at a potentially unfavorable price.

A preemptive exit strategy where the user repays the loan in full and withdraws their collateral before an automated liquidation occurs. This avoids liquidation penalties and potentially unfavorable prices from liquidation bots.

• Process: Requires having the full borrowed amount available or selling a portion of the collateral to generate the necessary funds for repayment.
• Use Case: Often used when market volatility is extreme and the user wishes to exit on their own terms rather than risk a 5-15% liquidation penalty.

If permitted by the protocol, users can substitute volatile collateral (e.g., ETH) for a more stable one (e.g., a stablecoin or wBTC) to reduce price volatility risk.

• How it works: On compound-like protocols, you may be able to withdraw one collateral asset and supply another with lower volatility or a better liquidation threshold.
• Consideration: This involves a swap transaction and may incur slippage and gas costs, but can structurally improve position stability.

Proactive monitoring is the first line of defense. Setting alerts for your collateral asset's price and your position's health metrics allows for early intervention.

• Key Metrics to Watch: Collateral Price, Health Factor / LTV Ratio, and Liquidation Threshold.
• Tools: Use portfolio dashboards (like DeBank, Zapper), protocol-specific UIs, or custom scripts with data from oracles like Chainlink to get real-time alerts before a margin call is triggered.

Maker's system uses a Collateralization Ratio to manage risk. When the value of locked ETH or other assets drops, the ratio falls. If it breaches the Liquidation Ratio for that vault type:

• The position becomes eligible for Keepers (liquidators).
• A Liquidation Penalty is applied to the debt.
• Keepers bid at auction to purchase the collateral, repaying the debt and penalty. The protocol's Stability Fee (interest) and Debt Ceiling are separate parameters that influence borrowing behavior before a call occurs.

These lending protocols use a Health Factor (HF), calculated as (Collateral Value * Liquidation Threshold) / Total Borrowed. When HF ≤ 1, the position is undercollateralized.

• Close Factor: Determines the maximum percentage of a borrow that can be liquidated in a single transaction (e.g., 50%).
• Liquidation Bonus: An incentive (e.g., 5-10%) given to liquidators on top of the seized collateral.
• Liquidations are performed via public function calls, often automated by bots monitoring the mempool.

Perpetual futures protocols like dYdX use a Maintenance Margin Requirement (MMR). A trader's account has an Account Value and Maintenance Margin (sum of MMR for all positions).

• Margin Call Trigger: Account Value ≤ Maintenance Margin.
• This initiates Auto-Deleveraging or allows liquidators to close the position at the bankruptcy price.
• The Initial Margin Requirement is higher, acting as a buffer before the maintenance level is breached.

The liquidation mechanism itself involves several key components:

• Liquidators: Network participants (often bots) who trigger the liquidation transaction.
• Liquidation Bonus/Penalty: The protocol-defined incentive paid to the liquidator from the borrower's collateral.
• Auction vs. Fixed Discount: Protocols use either a Dutch auction (Maker) or a fixed percentage discount (Aave) for selling collateral.
• Gas Wars: In fixed-discount systems, liquidators compete via transaction fee (gas price) prioritization to capture profitable opportunities.

The thresholds triggering margin calls are not static; they are Governance-controlled parameters. Key settings include:

• Liquidation Threshold: The collateral value at which borrowing becomes unsafe (e.g., 80% for ETH).
• Liquidation Bonus/Penalty: The size of the liquidator's incentive.
• Close Factor: The portion of debt liquidatable per transaction. Governance tokens (MKR, AAVE, COMP) are used to vote on adjusting these parameters in response to market volatility and protocol risk.

In extreme volatility, margin calls can create feedback loops:

• Mass liquidations flood the market, driving collateral prices down further.
• This triggers more margin calls (cascading liquidations).
• Can lead to bad debt if liquidation proceeds don't cover the borrowed amount. Protocols mitigate this with circuit breakers, auction duration adjustments, and risk parameter diversification across asset classes.