Liquidation Mechanics: Health Factors, Maintenance Margins and Liquidations

What actually happens inside a lending position when it goes wrong, and how the numbers decide who loses first. Liquidation is usually described as a punishment for bad positions, when it is more accurately a settlement mechanism that runs on fixed arithmetic.

Where the health factor comes from

Lending protocols accept collateral and lend against it. A borrower over-collaterates, usually above a protocol minimum, and the position stays solvent as long as the collateral value remains sufficient against the debt plus an added safety margin.

The health factor compresses that relationship into one number. Divide the value of collateral by the value of debt, adjusted by the liquidation threshold, and the result tells you how many times the position can deteriorate before it reaches the liquidation point.

Above one, the position is healthy. Below one, liquidators are permitted to repay part of the debt in exchange for discounted collateral. There is no negotiation and no discretion at that point; the arithmetic decides.

Maintenance margin and its purpose

The liquidation threshold sits below the maximum loan ratio on purpose. That gap is the maintenance margin, and it exists so a position is liquidated before it becomes bad debt.

If a protocol set the threshold equal to the maximum ratio, ordinary price volatility would push positions underwater without warning. The gap absorbs normal movement. A large move still breaches it, which is the real risk the borrower carries.

Thresholds differ by collateral and by protocol, so the same position can be comfortable in one market and a few minutes from liquidation in another. Compare thresholds rather than headline maximum loan ratios.

The liquidation penalty and why it is set high

Liquidators receive collateral at a discount to its oracle price. The discount compensates them for taking on the position and the risk that prices move further while a transaction is in flight.

Penalties in the range of a few percent are the norm. Higher penalties protect the protocol when collateral is volatile, and they are why a liquidation costs the borrower more than a market order at the same moment would.

The discount also creates a secondary market. Liquidators often hedge immediately, so the price impact of a large liquidation appears as slippage on the collateral market, not on the protocol itself.

Why liquidations cluster and slippage explodes

Liquidations tend to occur when volatility is already high. That is when the threshold gets crossed, which means the collateral is being sold into a market that is already thin and already falling.

The result is a loop: liquidators repay debt, receive collateral, and sell it, which pushes the collateral price lower, which pushes other positions closer to their own thresholds.

• Watch the ratio of collateral value to threshold, not the ratio to the maximum loan figure.
• Keep a margin buffer sized to ordinary volatility, not to the calm conditions when the position was opened.
• Reduce leverage when volatility rises, even if the position is currently profitable.
• Check whether the protocol uses an oracle that updates continuously or one that updates in steps.
• A liquidation can fail to execute at the intended price, leaving a borrower exposed for a further move.

Staying on the right side of it

The number that matters is the distance from the current price to the liquidation price, expressed as a percentage. Work backwards from that figure, including the penalty, and size the position so the remaining capital can absorb the difference.

Most liquidations are not caused by bad faith or bad luck. They are caused by a position that was sized for the calm market it was opened in.

Frequently asked questions

What health factor should a borrower target?

Comfortably above one, with the buffer sized to normal volatility for the asset. A number barely above one survives a quiet week and not much else.

Why can my liquidation price change without the price moving?

Because some oracles update in discrete steps or use a time-weighted average. The protocol's reference price shifts while the market price barely moves, which moves the liquidation point with it.

Is a liquidation penalty taken in cash?

Usually in the same asset supplied as collateral, though some protocols accept a different asset or offer a choice. The discount relative to the oracle price is what makes it attractive to liquidators.