Crypto's Liquidity Machine: The High-Speed Liquidation Process

The liquidation of leveraged crypto positions is a frequent occurrence in the market, often resulting in catastrophic losses for traders. In this guide, we will explore the two distinct systems that govern liquidation: derivatives exchanges and DeFi lending protocols.

Liquidation occurs when a trader's collateral value falls below a certain threshold, triggering a forced closure of their position. On derivatives exchanges, this happens when a trader's losses exceed their margin, while in DeFi lending protocols, it occurs when the health factor, a measure of a borrower's debt-to-collateral ratio, falls below 1.

In DeFi lending, liquidation is a paid job, with keeper bots competing to repay underwater borrowers' debts and seize their collateral. The bonus for these liquidators can be as high as 5% for major assets and more for volatile ones. This system allows lenders to recover losses without having to trust borrowers.

The importance of accurate oracle prices cannot be overstated, as they directly impact the health factor and, subsequently, the likelihood of liquidation. A single incorrect price feed can lead to the liquidation of healthy borrowers or the sparing of doomed ones.