Crypto's Automated Safety Net: How Liquidation Keeps Markets Solvent

Liquidation is a crucial mechanism in cryptocurrency markets that helps maintain solvency without relying on identity, courts, or credit scores. In essence, it's an automated way of ensuring that loans get repaid by selling collateral when the cushion between its value and debt shrinks.

There are two distinct systems for liquidation: one on derivatives exchanges, where leveraged perpetual-futures positions are force-closed when losses approach the margin, and another in DeFi lending protocols like Aave and Compound. In these platforms, overcollateralized loans are enforced by an open market of bots, called keepers or liquidators, that repay underwater borrowers' debts in exchange for their collateral at a discount.

On derivatives exchanges, liquidation is the endgame of leverage, where traders with positions several times the size of their margin face closure when losses erode the margin to the venue's maintenance threshold. In contrast, DeFi lending protocols use a health factor math to determine whether a position is safe or needs to be liquidated. If the health factor falls below 1, anyone can liquidate the borrower.

DeFi lending liquidation is an open market where hunters, or keeper bots, watch every loan on every protocol and simulate health factors against live prices. They compete to submit liquidation transactions the instant a position crosses 1, earning a liquidation bonus for their efforts. The capital to repay debt is often flash-borrowed, allowing the entire operation to complete inside one atomic transaction.