What is Liquidation?

Plain-English explainer · Updated 2026-07-27 · By DeFi Intel

Liquidation is the forced closure of an undercollateralized loan. Because DeFi lending protocols cannot pursue borrowers off-chain, they protect depositors with an automated mechanism: the moment a position's collateral value falls too close to its debt, anyone can step in, repay some of the debt, and claim the borrower's collateral at a discount. That discount — the liquidation bonus — is what makes running liquidation bots profitable and keeps the protocol solvent.

How it works

Every borrow position is scored continuously against oracle prices. On Aave, this score is the health factor: the value of the collateral weighted by each asset's liquidation threshold, divided by the value of the debt. As long as the health factor stays above 1, the position is safe. If collateral prices fall or the debt grows through accrued interest, the health factor decays — and once it drops below 1, the position becomes eligible for liquidation.

A liquidator then calls the protocol's liquidation function, repaying a portion of the borrower's debt — in Aave v3 the standard close factor allows up to 50% of the debt per call, and deeply unhealthy positions can be closed in full. In exchange, the liquidator receives an equivalent amount of the borrower's collateral plus a liquidation bonus. The bonus is set per asset by governance and scales with how risky the collateral is, compensating liquidators for gas costs and price risk while they unwind the seized assets.

For the borrower, liquidation is expensive: the bonus comes straight out of their collateral, on top of the market losses that triggered the event. Borrowers avoid it by keeping a conservative buffer — borrowing well below the maximum loan-to-value, adding collateral when markets fall, or repaying debt early. Some also use automation tools that top up or unwind positions before the health factor reaches the danger zone.

Why it matters

Liquidations are the backstop that lets lending protocols offer permissionless loans without credit checks. When they lag — during oracle failures or violent price crashes — protocols can accrue bad debt that ultimately falls on depositors.

Real-world examples

Aave v3 liquidates positions whose health factor falls below 1, letting liquidators repay up to half the debt (or all of it for deeply undercollateralized positions) in exchange for discounted collateral. Similar engines run on Compound, Morpho, and Spark, and on perpetuals exchanges where margin positions are force-closed.

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