Liquidation

You posted $10,000 in ETH as collateral and borrowed $6,000 in USDC. Then ETH dropped 40%. The protocol didn't call you — it just sold your ETH automatically to cover the loan. That's liquidation: a forced collateral sale triggered when your loan-to-value ratio climbs past the protocol's hard limit.

Borrowers care because it means losing collateral fast, often at the worst moment in a market downturn. Lenders care because liquidation is the mechanism that keeps their funds safe — without it, undercollateralized loans would default with no recourse.

How It Works

Every crypto loan has a liquidation threshold — the LTV ceiling above which the protocol acts. On Aave, ETH collateral carries an 82.5% liquidation threshold. That means if your $10,000 in ETH backs a $6,000 loan (60% LTV), you have room. But if ETH falls enough to push your LTV to 82.5%, the liquidation engine fires.

At that point, a liquidator — usually a bot — repays part of your debt and claims your collateral at a discount. That discount is the liquidation bonus, typically 5–10%. It compensates the liquidator for the gas cost and risk of acting fast. You lose collateral; the loan gets paid down; the protocol stays solvent.

The math moves faster than most people expect. A 20% drop in collateral value can close the gap between your current LTV and your liquidation threshold in minutes during a volatile market. There's no grace period, no phone call, no negotiation.

Why It Matters

For borrowers, the practical stakes are simple: if you're not watching your health factor — the protocol's real-time measure of how close you are to liquidation — you can lose a significant chunk of collateral without warning. A 5–10% liquidation penalty on top of a market loss compounds the damage fast.

What to Watch

The common mistake is borrowing close to the liquidation threshold because the rates look good. A 70% LTV might feel safe until a flash crash moves the market 15% in an hour. Maintaining a buffer — keeping your LTV well below the threshold, not just under it — is the single most important risk management habit in crypto borrowing.