Liquidations

The collateralization ratio is the primary metric determining liquidation risk. It's calculated as (Value of Collateral / Value of Debt). A position becomes undercollateralized and subject to liquidation when this ratio falls below the protocol's liquidation threshold.

• Example: If ETH is collateral with a 150% threshold, a $150 ETH position backing $100 of debt is at 150%. If ETH's value drops to $145, the ratio falls to 145%, triggering liquidation.

To ensure swift execution, protocols offer a liquidation incentive (or bonus) to liquidators—third parties who repay the bad debt. They can purchase the collateral at a discount, profiting from the difference.

• Mechanism: A liquidator repays part of the debt and receives a corresponding amount of collateral, valued at a price better than market.
• Purpose: This creates a competitive, decentralized marketplace for risk management, ensuring protocol solvency.

Used by protocols like Aave, the Health Factor is an inverse representation of risk. It is calculated as (Collateral Value * Liquidation Threshold) / Borrowed Value.

• Safe: Health Factor > 1.0
• At Risk: Health Factor <= 1.0 (liquidation triggered)
• Function: It provides a single, easily monitored number for users to gauge the safety of their leveraged position against market volatility.

Different protocols employ distinct methods for executing liquidations:

• Full Liquidation: The entire position is closed (common in earlier protocols like MakerDAO).
• Partial Liquidation: Only enough debt is repaid to restore the position to a safe collateralization level (e.g., Compound, Aave). This is less disruptive for the borrower.
• Dutch Auction: Collateral is sold via a descending price auction to find a market-clearing price (e.g., MakerDAO's Liquidations 2.0).

Liquidations are entirely dependent on accurate, timely price data. Protocols rely on decentralized price oracles (like Chainlink) to determine the value of collateral and debt assets.

• Critical Role: Oracle price feeds directly trigger liquidation events.
• Risk: Oracle manipulation or stale data can lead to unnecessary liquidations or, conversely, protocol insolvency if bad debt isn't liquidated in time.

A liquidation cascade (or avalanche) occurs when many positions are liquidated simultaneously, often during sharp market downturns. This can exacerbate price declines.

• Process: Large liquidations dump collateral onto the market, driving its price down further, which then triggers more liquidations.
• Mitigation: Features like partial liquidations, circuit breakers, and over-collateralization requirements are designed to reduce cascade risk.

Liquidators are economically incentivized by a liquidation bonus or liquidation fee, typically 5-15% of the seized collateral. This bounty is paid from the borrower's remaining collateral, making it profitable for actors to monitor and execute liquidations. The protocol's health fee is the primary driver for this critical market function.

Liquidations are almost exclusively performed by automated bots (keepers) that monitor blockchain state. These bots use sophisticated MEV (Maximal Extractable Value) strategies to be the first to submit a profitable liquidation transaction. Key steps include:

• Monitoring: Constantly checking on-chain prices and collateral ratios.
• Simulation: Pre-checking transaction profitability via nodes or services.
• Execution: Submitting a transaction with a high gas fee to win the block space.

When a borrower's Health Factor falls below 1 (e.g., due to asset price drops), their position becomes eligible. The liquidator repays a portion or all of the borrower's debt on their behalf. In return, the liquidator receives the equivalent value of the borrower's collateral, plus the bonus. This process is often atomic in a single transaction to prevent front-running.

Different protocols have distinct liquidation mechanisms that define the liquidator's role:

• Aave / Compound Style: Liquidators repay debt to receive discounted collateral.
• MakerDAO Auctions: Collateral is sold via collateral auctions (flip, flap, flap) where liquidators bid.
• Liquidation Thresholds: Protocols set specific Loan-to-Value (LTV) and Liquidation Threshold parameters that trigger events.

Liquidators are the first line of defense against protocol insolvency. If liquidators are inactive or inefficient, bad debt can accumulate, threatening the entire lending pool. Protocols may adjust bonuses or implement liquidation cascades during high volatility. The presence of robust, competitive liquidators is a key metric for protocol safety.

Liquidations are a major source of Maximal Extractable Value (MEV). In volatile markets, many positions can become undercollateralized simultaneously, creating a liquidation cascade. Searchers use bots to compete in a priority gas auction (PGA) to submit liquidation transactions first. This competition can drive up gas prices and lead to network congestion, representing a systemic risk and cost for users.

All liquidation mechanisms are governed by critical, adjustable parameters that define protocol risk:

• Liquidation Threshold: The collateral value ratio at which a position becomes eligible for liquidation.
• Liquidation Penalty/Bonus: The fee paid by the liquidated user or incentive given to the liquidator.
• Close Factor: Limits the amount liquidated per transaction to prevent instant, total loss.
• Health/Margin Factor: The real-time metric calculating a position's safety. Governance proposals often adjust these parameters in response to market conditions.

A liquidation is triggered when a borrower's collateralization ratio falls below a protocol's predefined liquidation threshold. This typically happens due to price volatility. For example, on Aave, if ETH collateral value drops, a position may become eligible for liquidation to protect the protocol from bad debt.

Key concepts:

• Health Factor: A numerical representation of a position's safety (e.g., a health factor below 1.0 triggers liquidation).
• Liquidation Bonus: The discount offered to liquidators as an incentive to close the risky position.

A liquidator is a bot or user that repays a portion of the borrower's debt in exchange for their collateral at a discount. This action restores the protocol's health and earns the liquidator a profit.

Process:

1. Monitor: Bots scan the blockchain for undercollateralized positions.
2. Calculate: Determine if the liquidation bonus exceeds gas and transaction costs.
3. Execute: Submit a transaction to repay debt and seize discounted collateral.

This creates a priority gas auction (PGA) as multiple bots compete to be first.

Liquidation opportunities are a primary source of Maximal Extractable Value (MEV). The competition to capture these profitable transactions leads to complex strategies within the MEV supply chain.

• Searchers: Run sophisticated algorithms to discover and bundle liquidation opportunities.
• Builders: Construct optimized blocks including these profitable transactions.
• Validators: Propose blocks, often selecting the most profitable ones from builders.

This supply chain can lead to negative externalities like network congestion and increased gas prices for regular users.

Different DeFi protocols implement unique liquidation mechanisms.

• Fixed Spread (MakerDAO): Liquidators purchase collateral via auctions (collateral auctions, debt auctions) at a fixed discount.
• Liquidation Call (Aave, Compound): Liquidators repay a portion of the debt to receive a fixed percentage bonus of the collateral.
• Dutch Auction (Liquity): Collateral is sold at a price that starts high and decreases over time, aiming for a more fair and decentralized process.

Each design has trade-offs between efficiency, fairness, and resistance to MEV.

While essential, liquidations pose significant risks to users and system stability.

For Borrowers: Sudden, total loss of collateral due to market swings or liquidation cascades. For the System: Bad debt can accumulate if liquidations are insufficient, threatening protocol solvency.

Protections include:

• Safety Modules & Insurance Funds: Protocols like Aave and Venus maintain capital reserves to cover shortfalls.
• Circuit Breakers: Some protocols temporarily disable borrowing or adjust parameters during extreme volatility.

Flash loans have become a fundamental tool for liquidators, enabling permissionless, capital-efficient attacks on undercollateralized positions.

How it works:

1. A searcher takes a flash loan for the required debt repayment amount.
2. Within the same transaction, they repay the borrower's debt, claim the discounted collateral, sell it on a DEX, and repay the flash loan.
3. The profit is the difference, minus fees.

This allows anyone to act as a liquidator without upfront capital, intensifying competition and MEV extraction.