Liquidation Threshold

In DeFi lending platforms, borrowers must lock up collateral to take out loans. The liquidation threshold is the risk parameter that defines how much can be borrowed relative to the collateral’s value. If the market moves and the loan-to-collateral ratio surpasses this threshold, the protocol may partially or fully liquidate the position to preserve solvency.

Each asset and protocol has its own liquidation threshold based on volatility and liquidity. Highly stable assets may have higher thresholds, while riskier ones are set lower to reduce systemic risk.

🔑 Key Characteristics Include:

• Defined per asset
• Varies across protocols
• Triggers liquidation when breached
• Core to borrower health and risk assessment

🏛 Example 1: Aave Protocol

Aave defines liquidation thresholds for every collateral asset. For instance, if the threshold for WETH is 80%, borrowing beyond that will put the position at risk of liquidation.

🏛 Example 2: Compound Finance

Compound uses a similar concept through collateral factors. If a user’s borrow exceeds the set factor (e.g. 75% for USDC), the position can be liquidated by third parties.

🏛 Example 3: MakerDAO

In MakerDAO, users mint DAI by locking up collateral. If the collateral value falls below a set ratio (e.g. 150%), a liquidation auction is triggered to repay the debt and stabilize the system.

📚 References

1. Coinbase – What is DeFi liquidation?
2. Krayon Digital – DeFi Liquidation Protocols: How They Work
3. RareSkills – DeFi Lending: Liquidations and Collateral
4. MixBytes – How Liquidations Work in DeFi: A Deep Dive
5. CoinGecko – DeFi Liquidations: What They Are and How to Monitor Them

⚠️ Controversies & Misconceptions

• Liquidation threshold is not the same as collateral ratio — the former triggers liquidation, the latter is the current ratio
• Crossing the threshold doesn’t always mean full liquidation — some protocols do partial liquidations
• It’s fixed — in some protocols, it can be adjusted by governance or risk teams

🚀 Conclusion

The liquidation threshold is a fundamental risk parameter in DeFi lending. It protects lenders, stabilizes protocols, and defines the safety margin for borrowers. Anyone participating in collateralized lending should know their threshold and monitor their position closely.

Related Terms

• Just-In-Time (JIT) Liquidity

  Just-In-Time (JIT) Liquidity is a strategy employed in decentralized finance (DeFi) where liquidity providers (LPs) add liquidity to a pool immediately before a large trade executes and remove it shortly after. This approach aims to capture trading fees from significant transactions without exposing the LPs to prolonged market risks.

• DeFi

  DeFi, or Decentralized Finance, refers to a financial ecosystem built on blockchain technology that operates without traditional intermediaries like banks or brokers. Instead, DeFi uses smart contracts on public blockchains—primarily Ethereum—to offer services such as lending, borrowing, trading, and earning interest.

• Borrowing & Lending

  Borrowing and lending in DeFi refers to the process of lending digital assets to earn interest (lending) or borrowing assets by providing collateral (borrowing). Unlike traditional finance, DeFi lending platforms operate without intermediaries, relying on smart contracts to facilitate loans and manage collateral.

• DAO (Decentralized Autonomous Organization)

  A Decentralized Autonomous Organization (DAO) is a community-led organization governed by smart contracts and token holders. DAOs operate without centralized leadership, enabling decentralized decision-making and resource allocation.