What is Liquidation?
Liquidation is a risk management mechanism that protects the protocol when a borrower’s position becomes undercollateralized. When a position’s health score drops below 1.0, liquidators can repay the borrower’s debt and receive collateral at a discount.Health Score
The health score measures how close a position is to being undercollateralized:- Health Score > 1.0: Position is healthy
- Health Score = 1.0: At liquidation threshold
- Health Score < 1.0: Position can be liquidated
Factors Affecting Health Score
- Collateral Value Changes: If collateral token price drops, health score decreases
- Debt Value Changes: If borrowed token price increases, health score decreases
- Interest Accrual: As interest accrues on debt, health score decreases
- Deposits/Withdrawals: Adding collateral increases health score; withdrawing decreases it
Liquidation Process
When Liquidation Occurs
A position becomes liquidatable when:- Health score drops below 1.0 (liquidation threshold)
- The position has enabled collateral
- The position has outstanding debt
Who Can Liquidate?
Anyone can act as a liquidator. Liquidators are incentivized by receiving:- The repaid debt amount
- A liquidation discount (bonus collateral)
Liquidation Discount
Liquidators receive collateral worth more than the debt they repay. The discount varies by vault but is typically 5-15%. Example:- Borrower owes: 1000 USDC
- Liquidator repays: 1000 USDC
- Liquidator receives: ~1100 USDC worth of collateral (10% discount)
Partial vs Full Liquidation
Partial Liquidation
Liquidators can repay a portion of the debt:- Repay 50% of debt → Receive 50% of collateral + discount
- Borrower keeps remaining position (if still healthy)
Full Liquidation
Liquidators can repay all debt:- Repay 100% of debt → Receive all collateral + discount
- Borrower’s position is closed
Liquidation Example
Alice has:- Collateral: 1 ETH (worth $2000)
- Debt: 1500 USDC
- Health Score: 1500 = 1.33
- New Health Score: 1500 = 0.93 (liquidatable!)
- Repays 1500 USDC debt
- Receives 1 ETH (worth 1540 value
- Profit: ~$40
Avoiding Liquidation
Monitor Your Health Score
- Check your health score regularly
- Set up alerts if possible
- Understand how price movements affect your position
Maintain a Buffer
Keep your health score well above 1.0:- Health Score > 1.5: Safe buffer
- Health Score 1.1-1.5: Monitor closely
- Health Score < 1.1: At risk
Actions to Improve Health Score
- Add Collateral: Increase collateral value
- Repay Debt: Decrease debt value
- Close Position: Repay all debt and withdraw collateral
Price Movement Impact
Understand how price changes affect your position: If collateral price drops:- Health score decreases
- May need to add collateral or repay debt
- Debt value increases
- Health score decreases
- May need to add collateral or repay debt
Liquidation Parameters
Each vault has configurable liquidation parameters:- Liquidation Threshold: Health score at which liquidation becomes possible (typically 1.0)
- Liquidation Discount: Bonus received by liquidators (typically 5-15%)
- Max Liquidation: Maximum percentage of debt that can be liquidated in one transaction
Cool-Off Periods
Some vaults may implement cool-off periods:- After a liquidation, the position may have a temporary protection period
- Prevents immediate re-liquidation
- Gives borrowers time to adjust their position
Bad Debt and Socialization
In extreme cases, if a position cannot be fully liquidated (e.g., collateral becomes worthless), bad debt may occur. Some vault configurations may socialize losses across all lenders, though this is rare and typically avoided through proper risk management.Best Practices
For Borrowers
- Monitor health score regularly
- Maintain a safety buffer (health score > 1.5)
- Understand the risks of your collateral and borrowed assets
- Have a plan for price movements
For Liquidators
- Monitor positions approaching liquidation threshold
- Calculate profitability (discount vs gas costs)
- Consider partial liquidations for large positions
- Use automation tools for efficiency