DeFi liquidation

DeFi liquidation describes the automated process by which a lending protocol sells a borrower’s pledged crypto collateral when its value falls below a required safety threshold, and this mechanism is the ecosystem’s emergency brake; it preserves solvency for lenders but it also transfers real risk to the borrower and distorts markets when executed under pressure. At its core the system relies on overcollateralisation, which means borrowers must deposit more value than they borrow, and the protocol encodes a liquidation threshold and a liquidation penalty into a smart contract so that the rules run without human discretion. Volatility is the central danger because crypto prices can move fast and large, and a temporary price swing can trigger liquidation even when the borrower could otherwise repay or top up collateral. When a position is liquidated a portion or all of the collateral is sold via on-chain auctions or by incentivised third-party actors, often at a discount to ensure a speedy sale, and that discount plus any fees becomes a realized loss for the borrower. This creates feedback effects because hurried sales depress market prices and can lead to cascading liquidations across correlated positions. Lenders benefit from the protocol’s ability to recover value, but they face risks too; if liquidated collateral cannot be sold at expected prices the protocol may still fall short of covering the loan, and protocol design choices determine how much shortfall is tolerated. Practical defence for borrowers is straightforward and disciplined: keep a healthy collateral buffer above the liquidation threshold, prefer less volatile assets when possible, monitor positions and price feeds frequently, add collateral or repay preemptively when markets move, and set automated alerts or stop rules in wallets. Better mitigation also includes using protocols with clear liquidation mechanics, audited smart contracts, transparent oracle sources, and predictable fees, because clarity reduces surprise. Understand that liquidation is not a punitive whim but a deterministic clause in the code that enforces credit risk in a permissionless market, and that learning to read contract terms and watch collateral ratios gives you control where the market otherwise dictates outcomes. Knowledge, vigilance and conservative margining are your primary tools to manage liquidation risk in DeFi.