Liquidations
Why Liquidations Exist
Liquidation is the safety mechanism that protects lenders from loss when borrowers' collateral can no longer cover their debt. Without liquidations, a lending protocol would face a fundamental problem: if collateral values drop below loan values, lenders would lose money.
Liquidations solve this by allowing third parties to step in and close undercollateralized positions before they become insolvent. Think of liquidators as the protocol's immune system - they eliminate unhealthy positions to keep the overall system safe.
Position Health: LTV and Health Factor
Every borrow position has a health status determined by its Loan-to-Value ratio, abbreviated as LTV.
Every market has a Liquidation-Loan-To-Value ratio, abbreviated as LLTV.
Loan-to-Value (LTV) Calculation:
LTV = (Loan Value) / (Collateral Value)Both values are denominated in the same units (typically the loan token) using the market's oracle price.
Example:
Collateral: 10 ALPH at $2.00 each = $20
Loan: 15 USDT = $15
LTV = $15 / $20 = 75%
Health Factor: A complementary metric showing distance to liquidation:
Health Factor = LLTV / Current LTVHealth Factor > 1.0 = Safe position
Health Factor = 1.0 = Exactly at liquidation threshold
Health Factor < 1.0 = Liquidatable position
Example continued:
If market LLTV = 85%
Health Factor = 0.85 / 0.75 = 1.133
Position is safe with 13.3% buffer
When Positions Become Liquidatable
A position can be liquidated when its LTV exceeds the market's LLTV (Liquidation Loan-to-Value). This happens through:
1. Collateral Price Decrease Your collateral loses value relative to the loan token.
Started: 10 ALPH at $2.00, borrowed 15 USDT (LTV 75%)
ALPH drops to $1.70: collateral now worth $17
New LTV: $15 / $17 = 88.2% > 85% LLTV → Liquidatable
2. Interest Accumulation Your debt grows over time due to accrued interest.
Started: Borrowed 15 USDT, collateral worth $20 (LTV 75%)
After 6 months: Debt grows to 17.1 USDT at 20% APR
New LTV: $17.1 / $20 = 85.5% > 85% LLTV → Liquidatable
3. Combined Effect Usually both factors contribute simultaneously.
The Liquidation Process
When a position becomes unhealthy, any third party can liquidate it through a simple transaction:
Step 1: Identify Target Liquidators monitor positions to find LTV > LLTV.
Step 2: Calculate Amounts Determine how much debt to repay and collateral to seize.
Step 3: Execute Transaction Liquidator calls the liquidation function, repaying debt and receiving collateral plus a bonus.
Liquidation Incentive Factor (LIF)
Liquidators don't work for free - they earn a bonus for performing this service. The Liquidation Incentive Factor (LIF) determines this bonus and varies based on the market's LLTV:
LIF Formula:
Example LIF values:
LLTV 98%: LIF = 1.006 (0.6% bonus)
LLTV 94.5%: LIF = 1.016 (1.6% bonus)
LLTV 86%: LIF = 1.05 (5% bonus)
LLTV 77%: LIF = 1.074 (7.4% bonus)
Why it varies: Lower LLTV markets are more conservative and rarely see liquidations, so they need higher incentives. Higher LLTV markets see more frequent liquidations, so lower incentives suffice.
Liquidation Example
Initial Position:
Collateral: 50 ALPH at $2.00 = $100
Borrowed: $70 USDT
LTV: 70%
Market LLTV: 86%
Market LIF: 1.05 (5% bonus)
Price Movement: ALPH drops to $1.72. Collateral now worth $86.
New LTV: $70 / $86 = 81.4% (still safe)
Interest Accrual: After time passes, debt grows to $74 from accumulated interest.
Updated LTV: $74 / $86 = 86.05% > 86% LLTV → Position is now liquidatable
Liquidation Execution: A liquidator steps in and:
Repays the full $74 debt
Receives collateral worth: $74 × 1.05 = $77.7
After Liquidation:
Borrower: Debt cleared, retains $10.45 of collateral
Liquidator: Spent $74, received $77.7, profit $3.7 (minus gas costs)
Lenders: Protected from loss, full debt was repaid
Partial vs Full Liquidation
Liquidators can choose to liquidate any portion of a position, from 1% to 100% of the debt. This flexibility allows:
Full Liquidation:
Simplest approach
Closes position completely
Best for small positions where gas costs matter
Partial Liquidation:
Liquidate just enough to restore health
Useful for large positions
Reduces market impact when selling seized collateral
Leaves borrower with remaining collateral
Example: Instead of liquidating the full $74 debt above, a liquidator might:
Repay only $10 of debt
Seize $10.21 of collateral
Position remains open with $64 debt and $75.79 collateral
New LTV: $64 / $75.79 = 84.4% (now healthy again)
Risk Management Best Practices
For Borrowers:
Maintain a Safety Buffer Don't borrow to the maximum LLTV. Leave room for price volatility and interest accumulation.
LLTV 86%: Keep LTV below 75%
LLTV 77%: Keep LTV below 65%
Monitor Regularly Check your position health frequently, especially during volatile markets.
Deleverage Proactively If LTV rises, repay debt or add collateral before liquidation hits.
For Lenders:
Understand Market Risk Each market's LLTV determines how much buffer exists before losses.
Diversify Spread capital across multiple markets to reduce concentration risk.
FAQ
Can I be liquidated if prices recover before liquidation executes? No. If prices recover and your LTV drops below LLTV before a liquidator acts, your position is safe again.
Is liquidation first-come-first-served? Yes. The first liquidator whose transaction confirms gets the opportunity. This can lead to competition and gas bidding.
What if no one liquidates my position? Liquidation is economically incentivized, so profitable positions typically get liquidated quickly. If no one liquidates despite profitability, it may indicate technical issues (oracle failure, extreme market conditions, etc.).
Can liquidations fail? Yes, if:
Position is no longer liquidatable (price recovered)
Another liquidator already closed it
Oracle returns stale data
Liquidator has insufficient balance
Smart contract logic prevents it due to a bug
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