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Liquidation is what happens when you don’t keep your loan safe (or if the market moves against you) and your collateral value drops below a certain threshold.
Liquidation is automatic and irreversible. There are no warnings or grace periods when your collateral value drops too low.
Think of it like this: imagine you borrowed £750 using £1,000 worth of ETH as collateral. If ETH’s price crashes, your £1,000 worth of ETH might suddenly be worth only £800. Now, your collateral no longer comfortably covers your £750 loan. Protocols can’t just cross their fingers and hope you’ll repay. Instead, they automatically sell (liquidate) your collateral to repay your debt and protect the lenders.

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When does Liquidation Happen?

Protocols use a “health factor” or “liquidation threshold” to measure how risky your loan has become.
Health factor above 1.5 is generally considered safe, while anything below 1.2 puts you at high risk of liquidation.
  • A high health factor = you’re safe.
  • A low health factor = you’re getting close to liquidation.
  • If it drops below 1 (or another set value, depending on the protocol), liquidation is triggered.
This all happens automatically, without warnings or phone calls from a banker. The smart contract enforces the rules instantly and impartially.

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How Liquidation Works

When you’re liquidated:
  1. Part or all of your collateral is sold off at a discounted price to liquidators.
  2. The debt you owed is repaid with the proceeds from this sale.
  3. If there’s any leftover collateral after repaying your debt, it usually gets returned to you.
Liquidation often involves a penalty fee (5 to 15%), meaning you lose more than just the borrowed amount.
This mechanism keeps the protocol solvent and ensures that lenders don’t lose money even if markets crash. How do you avoid liquidation? Just keep your health factor healthy. Regularly monitor your position and maintain a safe buffer.
Set up alerts or check your positions daily during volatile market conditions to avoid unexpected liquidations.
If your health factor starts dropping, you can deposit more collateral to bring it back up. Reducing your debt reduces the risk of liquidation.
Always maintain a health factor above 1.5 and consider partial repayment during market downturns to stay safe.