Detailed Instructions

Collateral is an asset deposited by a borrower to secure a loan from a lending protocol. It acts as a guarantee, protecting the protocol from losses if the borrower fails to repay. In DeFi, collateral is typically a cryptocurrency like ETH, WBTC, or a stablecoin, locked in a smart contract. The protocol uses the collateral value to determine the maximum amount a user can borrow. This creates a system of over-collateralization, which is fundamental to managing risk in a trustless environment.

• Identify Eligible Assets: Check the protocol's documentation or UI for the list of supported collateral assets. For example, Compound supports assets like ETH (0xC02aaA39b223FE8D0A0e5C4F27eAD9083C756Cc2) and USDC (0xA0b86991c6218b36c1d19D4a2e9Eb0cE3606eB48).
• Understand Collateralization: A user depositing $10,000 worth of ETH as collateral might only be allowed to borrow up to $7,000 of another asset, ensuring a safety buffer.
• Monitor Asset Volatility: Recognize that the value of crypto collateral is volatile. A sharp price drop can quickly erode this safety buffer, triggering a liquidation.

Tip: Always verify the smart contract addresses for collateral tokens on the protocol's official website or a block explorer to avoid scams.

Detailed Instructions

The Collateral Factor (CF), also known as the Loan-to-Value (LTV) ratio, is the maximum percentage of an asset's value that can be borrowed against. It is the primary risk parameter set by protocol governance. A higher collateral factor (e.g., 75% for stablecoins) means more borrowing power but increases protocol risk, as the collateral's value has less room to fall before becoming undercollateralized. A lower collateral factor (e.g., 50% for volatile assets) reduces borrowing power but creates a larger safety cushion.

• Calculate Borrowing Capacity: If you deposit 1 ETH worth $3,000 with a CF of 65%, your maximum borrow is $1,950 (3000 * 0.65).
• Compare Across Assets: Protocols assign different CFs based on asset risk. For instance, Compound v2 might set WETH at 82% and UNI at 65%.
• Check Governance Proposals: Risk parameters are not static. Monitor governance forums for proposals to change CFs, as seen in Compound Proposal 117 which adjusted several factors.

Tip: Your actual safe borrowing limit should be significantly below the maximum CF to avoid liquidation during normal market volatility.

Detailed Instructions

The Health Factor (HF) is a real-time metric indicating the safety of your borrowed position. It is calculated as (Total Collateral Value * Collateral Factor) / Total Borrows. A health factor below 1.0 means the position is undercollateralized and subject to liquidation. The Liquidation Threshold is effectively the Collateral Factor; when the borrowed value exceeds this threshold of the collateral value, liquidation occurs. Keeping a high health factor is crucial for risk management.

• Monitor Your Position: Use the protocol's interface or a dashboard like DeBank to track your health factor. A command to query it on-chain might look complex, but front-ends display it clearly.
• Example Calculation: If you have $10,000 of ETH (CF 75%) as collateral and have borrowed $5,000 of DAI, your HF is (10000 * 0.75) / 5000 = 1.5.
• Understand Liquidation: If ETH price drops, reducing your collateral value to $6,800, your new HF becomes (6800 * 0.75) / 5000 = 1.02. A further small drop will push it below 1.0, allowing a liquidator to repay part of your debt and seize a portion of your collateral, plus a liquidation bonus (e.g., 5-10%).

Tip: Set up price alerts for your collateral assets to get warned before your health factor approaches dangerous levels.

Detailed Instructions

Protocol risk is managed at a macro level by the collective configuration of all collateral factors. Governance must balance capital efficiency (higher CFs) with safety (lower CFs). The protocol's total borrowable value and its exposure to correlated asset crashes are direct functions of these settings. A poorly configured set of CFs can lead to mass liquidations and insolvency during market stress, as seen in historical events.

• Review the Risk Dashboard: Analyze the protocol's total collateral, total borrows, and utilization rates per asset. For Compound, you can query this data via The Graph.
• Assess Correlation Risk: If multiple major collateral assets (e.g., ETH and wBTC) have high CFs and their prices are correlated, a broad market downturn could trigger simultaneous liquidations across many users, straining the liquidation system.
• Examine Governance History: Study past proposals. For example, a proposal to increase the CF for a new asset will include a risk assessment from teams like Gauntlet or Chaos Labs, often recommending a conservative initial factor like 50%.

Tip: As a user or governance participant, favor conservative collateral factor increases for new or volatile assets to protect the long-term solvency of the protocol.

Detailed Instructions

Proactively managing your borrowed position is essential. Use simulation tools to stress-test your portfolio against potential market movements. Understand the actions you can take—depositing more collateral or repaying debt—to improve your health factor and avoid liquidation. Automation through DeFi Saver or Instadapp can help execute these actions when certain conditions are met.

• Use a Simulation Tool: Platforms like DeFi Saver offer "MakerDAO Simulation" modes for similar protocols. Input your collateral, debt, and CF to see how price changes affect your HF.
• Plan Your Actions: If your HF is falling, you can:
  • Deposit More Collateral: Send additional assets to the protocol to increase the numerator in the HF formula.
  • Repay Debt: Return some of the borrowed assets to reduce the denominator.
• Consider Automated Safety: Set up a recursive transaction using Gelato Network or a smart wallet to automatically add collateral if your HF drops below a set threshold (e.g., 1.5).

Tip: Always account for transaction fees (gas) when planning emergency actions, as network congestion during a market crash can make them prohibitively expensive.

Understanding the Core Concepts

In DeFi lending, collateral refers to the digital assets (like ETH, WBTC, or stablecoins) a user deposits into a protocol to borrow other assets. The Collateral Factor (CF), also known as the Loan-to-Value (LTV) ratio, is the maximum percentage of an asset's value that can be borrowed against it. For example, if ETH has a CF of 75%, a user depositing $100 worth of ETH can borrow up to $75 of another asset. This factor is set by governance and is a critical risk parameter.

• Identify Supported Assets: Check the protocol's documentation for the list of approved collateral assets and their specific CFs. For instance, Compound's cETH might have a CF of 82.5%.
• Understand Risk Tiers: Different assets have different CFs based on volatility and liquidity. Stablecoins typically have higher CFs (e.g., 85%) than more volatile assets like altcoins (e.g., 50%).
• Calculate Borrowing Capacity: Use the formula: Borrowing Capacity = Collateral Value * Collateral Factor. This determines your initial safe borrowing limit.

Tip: A lower CF is a safety buffer for the protocol but reduces your capital efficiency. Always verify the current CF on the protocol's UI or via its smart contracts.

Tracking Account Health in Real-Time

The Health Factor (HF) is a numerical representation of your loan's safety. It is calculated as (Total Collateral Value * Weighted Avg. Collateral Factor) / Total Borrowed Value. An HF above 1.0 means your loan is over-collateralized and safe. If it drops to or below 1.0, your position becomes eligible for liquidation. Protocols like Aave display this value prominently on their dashboards.

• Query Your Health Factor: You can check this on-chain. For example, on Compound, you might call getAccountLiquidity(address account) on the Comptroller contract.
• Set Up Alerts: Use DeFi monitoring tools or custom scripts to alert you when your HF falls below a threshold like 1.5.
• Understand the Impact of Price Volatility: If your collateral value drops or your borrowed value increases (e.g., due to interest accrual), your HF decreases. A 10% drop in ETH price can significantly impact HF if you are heavily leveraged.

Tip: Maintain a Health Factor well above 1.2 (e.g., 1.5-2.0) to create a buffer against market volatility and avoid sudden liquidations.

The Liquidation Process in Action

A liquidation is triggered automatically by smart contracts when a user's Health Factor falls below 1.0 (or a protocol-specific threshold like 1.0 on Compound). This means the borrowed amount is under-collateralized. Liquidators (any external party or bot) are then incentivized to repay a portion of the unhealthy debt in exchange for seizing the user's collateral at a discount. This discount is the liquidation incentive or bonus.

• Liquidation Conditions: The exact conditions are checked on-chain. For a user with address 0x123..., a liquidation call will fail if getAccountLiquidity(0x123...) returns a value >= 0.
• Liquidator's Action: A liquidator calls the liquidateBorrow function. For example, on Compound's cToken contracts:

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cErc20.liquidateBorrow(borrower, repayAmount, cTokenCollateral)

• Seizure at a Discount: The liquidator repays the debt (e.g., in DAI) and receives the borrower's collateral (e.g., cETH) at a value greater than the repaid amount. The discount rate is often around 5-10%.

Tip: The closeFactor (e.g., 50% on Compound) limits how much of a single borrow can be liquidated in one transaction, potentially allowing borrowers to save part of their position.

The Economics Behind Liquidations

Liquidators are profit-driven actors who maintain protocol solvency. Their primary incentive is the liquidation bonus—the difference between the market value of the seized collateral and the debt they repaid. For instance, a 5% bonus on a $100,000 liquidation yields a $5,000 profit (minus gas costs). This creates a competitive landscape where bots monitor the mempool and blockchain state for under-collateralized positions.

• Calculate Potential Profit: Profit = (Collateral Seized * Market Price) - Debt Repaid. This must exceed transaction (gas) costs to be viable.
• Common Strategies: Liquidators run sophisticated bots that:
  • Listen for HealthFactor updates from oracle price feeds.
  • Use flash loans to fund large liquidations without upfront capital.
  • Engage in gas price auctions to be the first to submit a liquidation transaction.
• Protocol Parameters: Incentives are defined in smart contracts. Check the liquidationIncentive (e.g., 1080000000000000000 for an 8% bonus in Wei) in the Comptroller storage.

Tip: As a borrower, understanding these incentives highlights the importance of maintaining a high Health Factor. As a potential liquidator, you need fast, low-latency infrastructure and capital to compete effectively.