A liquidation is the forced closure of a borrowing position whose collateral has fallen too close in value to its debt. A third party repays some or all of what the borrower owes, takes their collateral at a discount as payment, and the lender's capital is recovered before the position can go underwater.
It is the same function a margin call performs in a prime brokerage account, with two differences: it is automatic, and anyone with capital can execute it, and because it is the mechanism that makes uncollateralized-lender protection possible at all, it appears in every institutional DeFi risk framework.
What is a liquidation, and what triggers it?
A position becomes liquidatable the moment its debt exceeds the share of its collateral value that the market allows it to borrow. Each market sets a maximum ratio, the liquidation loan-to-value, meaning the highest acceptable debt-to-collateral ratio, and when actual loan-to-value crosses it the position is open to liquidation.
The health factor states the same condition as a single number: a distance from that line. In one common formulation it is the collateral value denominated in the loan asset, multiplied by the liquidation loan-to-value, divided by the amount borrowed, so above 1.0 the position is healthy and at or below 1.0 it can be liquidated.
Three things move that number, and none of them requires the borrower to do anything at all: collateral can fall in price, interest accrues so the debt grows on its own, or both happen at once. A position untouched for months can be liquidated purely because it kept paying interest into a flat market.
Every one of those checks runs on a price reported by an oracle, a contract that supplies the collateral's price to the market, and the market acts on the oracle's number rather than the price on any exchange screen. That number is the trigger.
Liquidators, and what pays them
Independent parties, usually automated bots, do it for a discount on the collateral. Nobody is appointed. The protocol exposes a function that any address can call against an unhealthy account, whoever calls it first is paid, and the payment is a bonus on the collateral seized.
One model calculates a liquidation incentive factor from the market's loan-to-value ceiling as min(M, 1/(β × LLTV + (1 - β))), with β set to 0.3 and M capped at 1.15, giving roughly a 5% bonus in a market with an 86% ceiling, and the entire amount goes to the liquidator with no protocol cut. Other designs handle it differently: in Compound III, "a liquidator (a bot, contract, or user) can call the absorb function", the protocol takes ownership of the collateral and returns its value minus a penalty to the borrower, and the liquidator's compensation is tracked rather than paid out directly.
Whether the system works depends on those economics: if the bonus is smaller than the gas and slippage cost of executing, nobody acts and the position keeps deteriorating.
Is a liquidation partial or full?
Both exist, and the difference decides how much the borrower loses. In a partial liquidation, only part of the debt is repaid, enough to bring the position back above the threshold, so the borrower keeps the rest of the position. A full liquidation closes the whole thing.
Some designs leave the choice to the liquidator. Morpho lets liquidators "repay up to 100% of the borrower's debt in a single transaction" or take a smaller amount, often to keep gas costs proportionate. Compound III's absorb function seizes the collateral and clears the debt outright, so that "the liquidated user has no remaining debt". Neither is more correct. Full liquidation is simpler and more punitive; partial liquidation is gentler on the borrower and can leave a position that needs liquidating again an hour later.
What is a liquidation cascade?
A sequence where liquidations push the collateral price down far enough to trigger further liquidations. Liquidators do not hold what they seize. They sell it, usually immediately, to lock in the bonus. Enough forced selling of one asset moves its market price, the oracle picks up the lower price, and positions that were healthy a minute ago cross their threshold.
Two failure modes sit at the end. Prices can fall faster than liquidators can transact, so the collateral seized is worth less than the debt repaid and part of the loan is never recovered. That shortfall is bad debt, and it lands on the market's lenders: some designs realize it immediately and share it proportionally across all suppliers, while others let unpaid debt sit on the books accruing indefinitely. The second mode is subtler. When a single collateral asset is used across many markets, or many markets read the same price feed, a cascade in one place arrives everywhere that shares the dependency.
How does this apply to an institution?
A lender or vault depositor is short the liquidation process working. Supplying into a lending market is a bet that positions collateralized by an asset you did not choose will be closed in time by parties you have no relationship with, whether or not you ever borrow yourself. The parameters that determine whether that holds, the loan-to-value ceiling, the size of the bonus, the depth of the collateral's market and the oracle's update behaviour, are all published and all worth reading before allocating.
Parameter selection, cascade modelling and live-position monitoring are the standing work. How DeFi lending works covers the supply side those parameters govern.
FAQ
What triggers a liquidation?
A position's debt rising above the share of collateral value the market permits. That happens when collateral falls in price, when accrued interest grows the debt, or both at once, and expressed as a health factor the position is healthy above 1.0 and liquidatable at or below it.
Who liquidates a position?
Any party willing to repay the debt, in practice automated bots competing for the reward. There is no appointed liquidator and no queue: the protocol exposes a function callable by any address against an unhealthy account, and the first caller is paid.
How much does a liquidation cost the borrower?
The penalty, meaning the discount the liquidator receives on the seized collateral, plus the loss of whatever position was closed, and the size is set per market and scales with the loan-to-value ceiling, since riskier markets need to pay more to guarantee someone acts.
What is bad debt?
Debt left unpaid after liquidation because the collateral seized was worth less than the loan. The loss falls on the market's lenders. Some protocols recognise it immediately and spread it across all suppliers; others leave it accruing on the books, so the reported figures overstate what is recoverable.