The Collateralization Ratio is the key metric determining a loan's safety, calculated as (Collateral Value / Debt Value) * 100%. It measures how over-collateralized a position is.

• A 150% ratio means $150 of crypto collateral backs $100 of debt.
• Protocols set a Minimum Collateralization Ratio (e.g., 110% for MakerDAO's ETH-A vault) as a liquidation threshold.
• Users must monitor this ratio; if the collateral's value falls, they risk liquidation unless they add more collateral or repay debt.

The Liquidation Threshold is the specific collateral value percentage at which a position becomes eligible for liquidation. Closely related is the Health Factor, a numerical representation of a position's safety.

• A Health Factor below 1.0 triggers liquidation (e.g., Aave, Compound).
• It is calculated as (Collateral Value * Liquidation Threshold) / Total Borrowed.
• This mechanism automatically protects the protocol from under-collateralized debt, ensuring lenders are always repaid.

The Liquidation Process is the automated sale of a user's collateral to repay their debt when their position becomes under-collateralized. Liquidation Incentives (bonuses) are critical for motivating liquidators.

• A liquidator repays part of the debt and receives collateral at a discounted price (e.g., 5-10% bonus).
• This creates a competitive market for liquidations, ensuring swift resolution.
• The process happens via smart contracts, often within a single transaction, minimizing systemic risk.

Price Oracles are trusted, decentralized data feeds that provide real-time asset prices to smart contracts. They are a critical prerequisite for determining accurate collateral values.

• Protocols like Chainlink aggregate data from multiple exchanges to prevent manipulation.
• An oracle reporting an inaccurate, lower price can trigger unnecessary liquidations.
• The reliability and security of the oracle are paramount for the entire system's stability and fairness.

A Collateralized Debt Position (CDP) or Vault is the user-created smart contract that locks collateral and mints debt (like DAI). It is the atomic unit managed in these systems.

• Users deposit assets (e.g., ETH) into a vault to borrow stablecoins against it.
• Each position has its own unique collateralization ratio and health factor.
• This structure allows for non-custodial, permissionless borrowing while isolating risk to individual positions.

Stablecoins (e.g., DAI, USDC) are the primary debt assets issued in over-collateralized systems. Their stability is essential for the lending/borrowing mechanism.

• Borrowers typically mint or borrow stablecoins to gain liquidity without selling their appreciating collateral.
• The protocol's stability depends on the debt asset maintaining its peg (e.g., $1 for DAI).
• This allows for predictable debt valuation, which is crucial for calculating accurate health factors.

A liquidation cascade occurs when multiple positions are liquidated in rapid succession, driving down collateral asset prices.

• Triggered by a sharp market drop, causing initial liquidations.
• Subsequent liquidations further depress prices, creating a feedback loop.
• Example: The 2020 'Black Thursday' on MakerDAO where ETH price crashes overwhelmed the system.
• This matters as it can rapidly erase user equity and threaten protocol solvency.

This risk stems from reliance on external price oracles for valuation. Incorrect or manipulated price feeds can trigger faulty liquidations.

• Oracle lag or downtime can use stale prices.
• Flash loan attacks can manipulate spot prices on a DEX that an oracle reads.
• Example: The bZx protocol exploit used flash loans to manipulate oracle prices.
• This matters because users can be unfairly liquidated, or the system can become undercollateralized without warning.

A liquidity crunch happens when insufficient market depth exists to absorb liquidation sales without significant price impact.

• Common with exotic or low-liquidity collateral assets.
• Liquidators may avoid unprofitable auctions if slippage is too high.
• Example: Liquidating a large WBTC position in a thin market could crash its price.
• This matters as it can cause bad debt to accumulate when liquidations fail to cover the loan.

This involves flaws in the liquidation incentive structure, such as discounts (penalties) and keeper rewards.

• If the discount is too small, liquidators lack motivation to participate promptly.
• If too large, it excessively punishes the liquidated user and can increase volatility.
• Example: A protocol may need to dynamically adjust discounts based on network congestion and asset volatility.
• This matters because improper incentives can lead to delayed liquidations or predatory behavior.

The foundational risk of bugs or exploits within the liquidation smart contracts themselves.

• Logic errors could allow liquidation without proper triggers.
• Integration risks with new collateral types or oracle systems.
• Example: The Harvest Finance exploit where a flawed strategy contract was drained.
• This matters as it represents a single point of catastrophic failure, potentially leading to total loss of locked funds.

High and volatile gas prices can prevent timely liquidations during market stress, as transactions become prohibitively expensive.

• Liquidators' profit margins are eroded by high gas costs.
• Users cannot top up collateral or repay debt if transactions fail.
• Example: During the 2021 bull run, Ethereum congestion made many liquidation transactions economically non-viable.
• This matters because it cripples the core risk mitigation mechanism precisely when it is needed most.