Liquidation Ratio

The liquidation ratio (also known as the liquidation threshold) is the minimum collateral-to-debt value ratio a borrower must maintain in a collateralized debt position (CDP). It is expressed as a percentage, such as 150%. If the value of the deposited collateral falls below this threshold relative to the borrowed amount, the position becomes eligible for liquidation. At this point, a third-party liquidator can repay part or all of the debt in exchange for the collateral at a discount, a process designed to protect the protocol from bad debt.

This mechanism is a core component of overcollateralized lending, where users lock crypto assets like ETH to borrow stablecoins or other tokens. The ratio is set by protocol governance based on the volatility and liquidity of the collateral asset; riskier assets require higher ratios. For example, a stablecoin like DAI used as collateral might have a 110% ratio, while a more volatile asset like ETH might require 150%. The collateral factor on Compound or the health factor on Aave are analogous concepts that serve the same protective function.

When market prices drop, a borrower's collateralization ratio—the current value of their collateral divided by their debt—declines. If it crosses the liquidation threshold, an automated smart contract triggers the liquidation process. The liquidation penalty (or bonus) is an additional fee paid to the liquidator, making the process economically incentivized. This system ensures the protocol remains solvent, as the liquidated collateral always covers the debt plus the penalty, preserving the integrity of the lent assets.

The liquidation ratio is the minimum permissible ratio of a position's collateral value to its borrowed value, expressed as a percentage. For example, a 150% ratio means the collateral must be worth at least 1.5 times the loan value. This threshold acts as a safety buffer, or collateral factor, for the lending protocol, protecting it from losses if the collateral asset's price declines. When the collateralization ratio of an open position falls below this predefined threshold due to market volatility, the position becomes eligible for liquidation.

The mechanism is monitored continuously by keepers—network participants incentivized by liquidation rewards. They monitor oracle price feeds for collateral assets like ETH or WBTC. If the value drops, causing the live collateralization ratio to breach the liquidation threshold, a keeper can trigger a liquidation event. This process involves automatically selling a portion of the borrower's collateral, often at a slight discount (a liquidation penalty), to repay the outstanding debt and associated fees, thereby restoring the health of the protocol's loan book.

Setting this ratio involves a trade-off between capital efficiency and protocol security. A lower ratio (e.g., 110%) allows borrowers to take on more debt per unit of collateral but increases systemic risk. A higher ratio (e.g., 200%) is more conservative but requires more locked capital. Protocols like MakerDAO allow governance token holders to vote on these parameters per collateral asset type, adjusting for volatility and liquidity. This dynamic management is essential for maintaining the stability of the overcollateralized lending system.

For a borrower, understanding the liquidation ratio is paramount for risk management. It requires active monitoring of the health factor or collateral ratio of one's position. A common strategy to avoid liquidation is to maintain a significantly higher collateralization ratio than the minimum, providing a buffer against normal market swings. Alternatively, borrowers can deposit additional collateral or repay a portion of the debt to increase their ratio when prices fall, a process known as recollateralization.

The liquidation ratio (also called the collateralization ratio or minimum collateral ratio) is a critical risk parameter in overcollateralized lending protocols that defines the minimum value of collateral required relative to the debt borrowed. It is expressed as a percentage, such as 150%, meaning the collateral must be worth at least 1.5 times the loan value. This buffer protects the protocol from losses if the collateral asset's price declines, ensuring there is sufficient value to cover the debt even in volatile markets. When a user's collateral ratio falls below this threshold due to market movements, their position becomes eligible for liquidation.

Managing the liquidation ratio is a fundamental act of risk management for both borrowers and protocols. For borrowers, maintaining a healthy margin above this ratio is essential to avoid the penalty of liquidation. For protocol designers, setting this parameter involves a trade-off: a higher ratio (e.g., 200%) increases safety but reduces capital efficiency for users, while a lower ratio (e.g., 110%) increases leverage and risk. Protocols often set different ratios for different asset pairs based on the volatility and liquidity of the collateral asset—stablecoins typically have lower ratios than more volatile assets like cryptocurrencies.

The liquidation process is triggered automatically when the current collateral ratio, calculated as (Collateral Value / Debt Value) * 100, dips below the protocol's defined liquidation threshold. This is not a single moment but a continuous check, often by keeper bots monitoring oracle price feeds. Once triggered, a portion of the borrower's collateral is sold at a discount to repay their debt, plus a liquidation penalty, restoring the health of the overall lending pool. This mechanism is the primary defense against undercollateralized positions and systemic insolvency in DeFi money markets like Aave and MakerDAO.