Liquidation is what happens when a leveraged position can no longer cover its debts and the lending protocol forcibly closes the position to protect the lenders. If you borrow $10,000 of USDC against $15,000 of ETH collateral, and ETH drops far enough that your collateral is now worth $11,000, the loan is approaching the point where a further price drop would leave the lenders with less than they are owed. The protocol does not wait for that to happen: it sells your collateral (or lets a third party do so) at a discount, uses the proceeds to repay the debt, and what is left after paying the liquidation penalty gets returned to you. Usually that remainder is much smaller than you started with, and if the drop was sudden enough, there may be nothing left at all.
Every major DeFi lending protocol — Aave, Compound, Maker/Sky, Morpho, Spark — works on roughly this model, with some variations in the specific mechanics. Aave uses auction-style liquidations where any address can trigger the liquidation and claim a bonus for doing so. Maker (now Sky) uses auctions that let bidders compete for the collateral at a rising price. The differences matter for professional liquidator bots but not much for the person being liquidated, who experiences essentially the same outcome in all cases: their position closes, they lose a chunk of their collateral, and the market moves on.
The Liquidation Cascade
Individual liquidations are a normal and necessary part of any lending market. They become a problem when they happen all at once. A sharp price drop can push many leveraged positions below their liquidation thresholds simultaneously. Liquidators begin selling collateral into the market, which pushes prices down further, which triggers more liquidations, which pushes prices down more. This is a liquidation cascade, and it is the mechanism behind some of crypto’s most violent price moves.
The May 19, 2021 crash is the canonical example: Bitcoin dropped from around $42,000 to around $30,000 in a few hours, triggering roughly $9 billion of liquidations across centralised and decentralised venues. Prices went much lower than they would have in an orderly market, because so much forced selling was hitting the book at once. The March 12, 2020 Black Thursday event was worse in DeFi specifically: ETH dropped 50 percent in a day, MakerDAO’s liquidation system failed under the load (some liquidations auctioned collateral for zero DAI because network congestion prevented competing bidders from joining the auction), and Maker ended up with a bad debt that had to be covered by emergency MKR dilution.
These events are rare but they are the situations where leveraged positions go most wrong. Liquidation models assume that liquidators will reliably show up and bid something reasonable for collateral. When the network is congested, when prices are moving faster than oracles can update, or when everybody is trying to exit at once, that assumption breaks, and the system can end up worse off than its parameters would suggest.
How to Avoid Getting Liquidated
The naive answer is: keep your collateral ratio high and do not borrow close to the maximum. If the protocol allows a maximum LTV of 80 percent, borrowing at 50 percent gives you a large cushion against adverse price moves. The smaller the cushion, the smaller the price drop needed to put you at risk, and crypto prices can move 20-30 percent in a day during volatile periods.
The more sophisticated answer is to actively monitor the position, set up alerts on services that track your collateral health, and be willing to top up collateral or repay debt when the ratio moves against you. Professional DeFi users run bots that do this automatically, but for retail users, a manual watch-and-respond approach works fine if you check frequently enough. The specific margin you need depends on the volatility of the collateral asset, the borrowing rate, and how closely you are willing to pay attention. For borrowing against ETH, most careful users stay below 50 percent LTV as a rule, and crypto-native lenders on stable-stable loops can go much higher because the underlying assets are more stable.
The thing you do not want to do is borrow the maximum, not monitor the position, and assume the market will be calm. It will not be calm at the worst possible time, and you will find out what liquidation feels like the hard way.