Liquidation

Liquidation is the forced closure of a leveraged or collateralized borrowing position when the value of collateral falls below the minimum threshold required by the lending protocol. When collateral value drops due to price movements, the protocol automatically sells the borrower's collateral to repay the outstanding debt and protect lenders from losses. This mechanism ensures that lending protocols maintain solvency and that lenders' funds are protected even during volatile market conditions. Example: On Aave, if a borrower deposits 10 ETH as collateral to borrow stablecoins and ETH's price drops significantly, their position falls below the maintenance ratio, triggering automatic liquidation where liquidators purchase the discounted collateral to repay the debt. Why it matters for DeFi: Liquidation risk directly affects borrowers' capital efficiency and potential losses, making it critical to monitor collateral ratios. Liquidators earn rewards for executing these transactions, creating an important incentive mechanism that keeps lending protocols solvent and functional.

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