What is Liquidation?

Liquidation is a mechanism in lending protocols where collateral is automatically sold if a loan becomes undercollateralized. For example, if you borrow $1000 USDC with $2000 ETH collateral (200% collateralization), and ETH price falls to $800, your collateral ratio drops to 80%below the required 150%.

How does Liquidation work?

Liquidation operates as:

Borrower deposits collateral and borrows against it.
Collateral price falls.
Collateral/debt ratio falls below minimum threshold.
Anyone can call liquidation function.
Liquidator purchases collateral at discount (e.g., 5% below market).
Liquidator repays loan using their own funds.
Liquidator keeps the collateral.
Borrower loses collateral and any debt not covered. Liquidation incentivizes liquidators (opportunity to buy at discount) to maintain protocol solvency.

Why does Liquidation matter?

Liquidation is critical for protocol safety: it removes undercollateralized loans preventing defaults. Liquidation incentivizes borrowers to maintain collateral ratios or face losses.

Key features of Liquidation

Automatic when collateral falls below ratio
Collateral sold at discount
Liquidator profits from discount
Protects protocol from defaults
Incentivizes safe leverage
Common in lending protocols

Examples of Liquidation

Borrow $1000 USDC with $2000 ETH collateral. ETH price falls 50% to $1000 value.

Liquidation triggered.

Your $2000 collateral sold for $1900 to liquidator. Liquidator earns $100 profit, repays your loan.