Liquidations & Cascades
When collateral falls too far, loans get force-closed automatically — and that forced selling can push prices down enough to trigger more of it.
DeFi lending (lesson 26) has no banker to phone you when your loan is in trouble — so what happens when the collateral backing a loan suddenly loses value? The system can’t send a friendly reminder; it acts automatically and instantly, and the way it acts can, on a bad day, turn one falling price into a self-reinforcing crash. This is the mechanism behind many of crypto’s scariest single-day drops. It builds directly on collateral (lesson 26), liquidators (the MEV of lesson 29), and price feeds (oracles, lesson 15). Hold the question: with no human in the loop, how does a loan get closed when its collateral drops — and how could that spiral?
The trigger: the collateral ratio breaks
Recall from lesson 26 that a DeFi loan is overcollateralized: to borrow $100 you might lock $150 of a volatile asset. The protocol constantly watches your collateral ratio — the value of your collateral versus what you owe — using a price feed (an oracle, lesson 15). Every loan has a liquidation threshold: a minimum ratio you must stay above. If your collateral’s price falls enough that you cross it (say your $150 of collateral drops toward $115 against a $100 debt), the position becomes eligible for liquidation — the protocol allows your collateral to be sold to repay the loan, without asking you. No phone call, no grace period: the code just enforces the rule.
Who pulls the trigger: liquidators earn a bonus
The protocol itself doesn’t sell — it offers a reward to anyone who will. A liquidator (in practice, an MEV bot from lesson 29) repays part of your debt and, in exchange, is allowed to seize your collateral at a discount — a liquidation bonus of, say, 5–10%. That discount is the incentive that guarantees someone is always watching and ready to act the instant you cross the line. It’s elegant: the system stays solvent because keeping it solvent is profitable for a competitive swarm of bots. The cost falls on the borrower, who loses collateral at a discount plus a penalty — which is exactly why staying well above your threshold matters.
A single liquidation: • You lock $150 of a token, borrow $100. Liquidation threshold: collateral must stay above $115. • The token drops 25%; your collateral is now worth ~$112 — below the line. • A liquidator repays your $100 debt and seizes ~$105–$110 of your collateral (with the bonus). Your loan is closed, the pool is made whole, and you’re left with the scraps. The bot pocketed the discount.
The cascade: selling that feeds on itself
Now the danger. Liquidation means selling collateral on the market — and a big forced sale has price impact (lesson 25): it pushes the collateral’s price down. But a lower price pushes other borrowers’ collateral ratios down too, tipping them below their thresholds, which triggers their liquidations, which sell more, which drops the price further… A cascade is this feedback loop: liquidations causing the very price falls that cause more liquidations, all in minutes, with no human able to stop it. It’s worst when many borrowers hold the same collateral at similar leverage, and when markets are thin. This is the honest risk of leverage in DeFi: it’s not just your position that can unwind — a crowd of leveraged positions can unwind each other. Reason about it before you borrow, not during the crash.
Picture climbers roped to the same mountain ledge, each also tied to a heavy pack (their debt). A rule says: if any climber slips below a marked line, a ranger immediately cuts them loose to protect the rope — and the ranger keeps a bit of their gear as payment. Fine for one slip. But when the whole ledge shudders, one climber drops below the line, gets cut, and the jolt of their fall shakes the ledge harder — dropping the next climber below the line, and the next. Each rescue makes the shaking worse. That chain of cut-loose climbers, each triggering the next, is a liquidation cascade: individually sensible rules combining into a collective avalanche.
How one drop becomes a cascade: 1. A popular token is used as collateral by thousands of leveraged borrowers at similar ratios. 2. Bad news knocks the token down 15%; the most-stretched borrowers cross their thresholds. 3. Liquidators sell that seized collateral into the market → price impact drives the token down further. 4. The lower price pushes the next tier of borrowers below their thresholds → more forced selling → more price drop. Within minutes a 15% dip has become a 40% collapse — not from new news, but from the liquidations feeding themselves.
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