What is a Liquidation Threshold?
The liquidation threshold is the critical collateral ratio at which a leveraged position or loan becomes eligible for forced closure. When your collateral value falls to this level relative to your debt or position size, liquidators can step in to repay your debt and claim your collateral, typically at a discount. Understanding liquidation thresholds is essential for anyone using leverage or borrowing in DeFi.
Different protocols set different liquidation thresholds based on asset volatility and risk parameters. Stablecoins might have thresholds of 90% or higher (allowing 90% of value to be borrowed), while volatile assets might have thresholds of 75% or lower. These thresholds are governance-determined and represent the protocol's risk tolerance.
How it Works
Liquidation thresholds define the boundary between safe and liquidatable positions. The threshold is usually expressed as a percentage of collateral value that can be borrowed. If you deposit $100 of collateral with an 80% liquidation threshold, you can borrow up to $80 before becoming liquidatable.
The calculation involves comparing your collateral value to your debt value. As collateral prices fall or debt values rise, the ratio approaches the threshold. Once crossed, any liquidator can trigger the liquidation process, repaying part or all of your debt in exchange for your collateral plus a liquidation bonus (their incentive).
In practice, the health factor metric in protocols like Aave directly relates to the liquidation threshold. A health factor of 1.0 means you are exactly at the liquidation threshold. Below 1.0, you are liquidatable. Different assets contribute differently to your overall health factor based on their individual liquidation thresholds.
Practical Example
On Aave, ETH has a liquidation threshold of 82.5%. You deposit $10,000 worth of ETH as collateral and borrow $7,000 in stablecoins. Your current loan-to-value is 70%, safely below the 82.5% threshold.
If ETH's price drops by 15%, your collateral is now worth $8,500, making your loan-to-value 82.4% ($7,000 / $8,500), just below liquidation. Another small decline puts you over the threshold, allowing liquidators to repay your debt and claim your ETH at a discount.
To calculate your liquidation price: if you borrowed 70% LTV with an 82.5% threshold, you can sustain approximately a 15% price decline before liquidation ((82.5-70)/82.5 = 15.15%).
Why it Matters
Liquidation thresholds determine how much cushion you have in leveraged positions. Conservative borrowers stay well below thresholds, maintaining buffers against volatility. Aggressive borrowers who maximize borrowing capacity near thresholds face heightened liquidation risk during normal market fluctuations.
Understanding thresholds helps with position sizing and risk management. Each asset has its own threshold based on volatility and liquidity, so a diversified collateral portfolio has a blended effective threshold. Monitoring your proximity to liquidation thresholds should be a continuous practice when using leverage.
Thresholds also vary across protocols. The same asset might have an 80% threshold on one platform and 75% on another, affecting how much you can borrow and your liquidation risk. Comparing thresholds is part of evaluating which protocol to use for leveraged strategies.
Fensory tracks liquidation thresholds across major DeFi lending protocols, helping you understand your exact liquidation prices and maintain safe distances from dangerous threshold levels.