In DeFi, liquidation is the forced selling of a borrower collateral when its value falls below the protocol minimum collateral ratio, protecting lenders from losses. Liquidations are automated by smart contracts and executed by liquidators – bots or users who repay a portion of the borrower debt in exchange for receiving the collateral at a discount (the liquidation bonus, typically 5-15%). Example flow: a borrower deposits $10,000 ETH as collateral and borrows $7,000 USDC (70% LTV). If ETH falls 30% to $7,000, their LTV hits 100% – the protocol triggers liquidation. A liquidator repays $3,500 of USDC debt and receives $3,850 of ETH ($3,500 plus 10% bonus). The borrower loses their ETH collateral but their USDC debt is reduced. Cascade liquidations – where one large price drop triggers thousands of simultaneous liquidations, further depressing prices – are a systemic DeFi risk. To avoid liquidation: maintain LTV well below the maximum, add collateral during market drops, set price alerts, or use protocols with gradual liquidation curves.
Example: Example: In May 2021, ETH dropped 45% in 3 days. DeFi protocols processed over $1 billion in liquidations on Aave and Compound alone. Borrowers who maintained 150%+ LTV survived; those at 120% were liquidated. Liquidation bots competed to process positions first for the bonus – gas fees spiked to $500+ per transaction as bots prioritised profitable liquidations.
Learn more: Aave – Liquidation Risk
