Liquidations and Cascade Risk
When a leveraged crypto position's collateral falls below what its loan requires, it gets forcibly closed — and because that forced selling pushes price down further, one liquidation can trigger the next.
Prerequisites: DeFi Lending and Utilization Curves
Borrow $8,000 in stablecoins against $10,000 of a volatile token as collateral, and the loan is fine as long as the collateral stays comfortably above the debt. Let the token's price fall and that cushion shrinks. Cross a threshold set by the protocol, and the position gets forcibly closed — sold, whether the borrower agrees or not. That forced sale is a liquidation, and it is the mechanism that keeps leveraged crypto lending solvent without a bank's ability to just call the borrower and ask for more collateral.
A position is liquidated when collateral value falls to a fixed fraction of debt, called the liquidation threshold. The liquidation itself is a forced sale into the open market — and because that sale pushes price down, it can trigger the next position's liquidation, turning one bad trade into a cascade.
How the trigger works
Every collateralized loan has a health factor, roughly the ratio of collateral value to debt, scaled by how conservative the protocol wants to be:
In words: take what the collateral is worth, discount it by a safety margin the protocol sets (say, only counting 80% of its value), and compare that to what's owed. As long as , the position is safe. The moment drops to 1, a liquidator — anyone, usually a bot — can step in, repay part of the debt, and seize the discounted collateral as a reward, often called a liquidation bonus.
Worked example
A trader deposits $10,000 of ETH as collateral and borrows $7,000 in stablecoins, at a protocol liquidation threshold of 80%. Their health factor starts at . If ETH drops 15%, collateral value falls to $8,500, and — below 1, so the position is now eligible for liquidation. A liquidator repays some of the $7,000 debt and receives ETH collateral worth that amount plus a bonus (commonly 5–10%), meaning the borrower loses both their collateral and pays an effective penalty for having been under-margined.
What this means in practice
Liquidations are individually rational — the protocol needs someone incentivized to act fast — but collectively they're what makes crypto crashes sharper than the initial news would suggest. A 10% drop can force enough leveraged positions to sell simultaneously that it becomes a 20% drop, which triggers the next band of thresholds, and so on. This is the same mechanical logic as a margin call cascade in traditional markets, compressed into minutes instead of days because liquidation bots operate continuously and settlement is instant.
Health factor is not a fixed cushion — it moves with price, and the closer a position sits to , the less price movement it takes to wipe it out. Traders often underestimate how a modest, ordinary-looking drawdown can be amplified by everyone else's leverage unwinding at the same threshold, not just their own.
Related concepts
Practice in interviews
Further reading
- Aave Protocol Documentation, 'Liquidations'