What is liquidation?
- Author
- CRYPTO PORT Editorial
- Published
- Updated
- Reading time
- 5 min
In short
Liquidation is the forced sale of collateral when a debt grows too large relative to it. It can be triggered by the collateral falling or by the borrowed asset rising, and it is carried out not by an operator but by third parties who profit from doing it. A penalty is applied on top, so the borrower ends up with less than the raw arithmetic suggests.
Key points
- Triggered when debt grows too large against collateral
- A rise in the borrowed asset can trigger it too
- Third parties execute it for a reward, not the protocol team
- A liquidation penalty costs the borrower extra
Definition
The process of selling a borrower's collateral to repay their debt once the ratio between the two crosses a defined threshold. In most protocols any third party may execute it in exchange for a reward.
A smart contract evaluates the position against prices supplied by an oracle. The instant the threshold is breached, anyone may liquidate. The liquidator repays part of the debt and receives collateral at a discount to market price in return. That discount is their reward and the borrower's loss.
The common misreading is that only a fall can cause it. Borrowing stablecoins against ETH, yes, a falling ETH price is the danger. But borrow ETH against stablecoins and a rising ETH price does the same damage. What matters is the relative price of the two assets, and it can move either way.
In crashes, liquidations cascade. Collateral sold into a falling market pushes the price lower, which pulls other positions across their thresholds. Past sell-offs have concentrated huge volumes of liquidations into minutes, executed at far worse prices than expected. Keeping a wide buffer is close to the only defence against that chain.
Watch out for
- · Liquidations happen without notice, and there is no appeal or reversal
- · During congestion your top-up transaction may not confirm in time to prevent it
- · If the oracle price is briefly distorted, positions can be liquidated at prices the market never really traded