Liquidation

The process in DeFi where assets from an under-collateralized loan are sold to repay the borrowed amount, typically triggered automatically by smart contracts when collateral value falls below a required threshold.

What is Liquidation?

In decentralized finance (DeFi), liquidation occurs when a borrower’s collateral in a lending protocol, such as Aave, Compound, or MakerDAO, drops below the minimum collateralization ratio, prompting the protocol to sell the collateral to cover the outstanding loan. DeFi lending platforms require over-collateralization (e.g., depositing $150 in ETH to borrow $100 in USDT) to mitigate risk. If the collateral’s value falls due to market volatility—say, ETH’s price drops significantly—the loan becomes under-collateralized, triggering an automatic liquidation by the protocol’s smart contracts to recover the lent funds.

For example, in MakerDAO, if a user’s collateralization ratio falls below 150% for a vault (e.g., due to a 30% ETH price drop), the protocol auctions the collateral (ETH) to repay the borrowed DAI plus a liquidation penalty (often 3-13%). Liquidators, often bots or arbitrageurs, bid on the collateral at a discount, profiting from the difference. Data from DeFiLlama shows liquidations in major protocols like Aave have processed over $2 billion in collateral since 2020, especially during market crashes like May 2022. Liquidation protects lenders but can lead to significant losses for borrowers, who lose their collateral and may face penalties.

The process is a frequent topic on platforms like X, where users discuss strategies to avoid liquidation, such as maintaining high collateral ratios or using stablecoin collateral to reduce volatility risk. Tools like DeFiSaver or Chainlink price oracles help monitor and manage liquidation risks. However, users must be cautious of flash crashes or oracle failures, which can trigger unexpected liquidations, as seen in historical DeFi exploits.