Lending and liquidation
Borrow against collateral from a contract that never negotiates. When the ratio breaks, the sale is automatic, immediate and public.
A lending protocol is a pool. Depositors add assets and earn interest; borrowers post collateral and take out a smaller value of a different asset. No credit check, no application, no counterparty — just a contract enforcing a ratio.
The mechanics
- Collateral factor. How much you may borrow against a given asset — perhaps 75% for a liquid one, far less for a volatile one.
- Health factor. The ratio of your collateral value to your debt, adjusted for those factors. Below the threshold, you are liquidatable.
- Liquidation. Anyone may repay part of your debt and seize collateral at a discount. Permissionless, automatic and instant.
- Utilisation-based rates. Interest is a function of how much of the pool is borrowed. Heavy borrowing raises rates for everyone until supply arrives or borrowers repay.
Deposit $10,000 of collateral with a 75% factor, and borrow $5,000. Your borrowing power is $7,500, so you are using two-thirds of it. If the collateral falls 30% to $7,000, borrowing power drops to $5,250 — still above the debt, barely. A 35% fall puts borrowing power at $4,875 against a $5,000 debt, and the position is liquidatable. A third of the way down, not half.
Liquidation is not a margin call
A broker may call you and give you until the close. A contract cannot. The instant the health factor crosses the threshold, liquidators — mostly automated bots watching every block — compete to execute, because the discount they receive is their profit. This happens in seconds, at any hour, and it is designed to.
Cascades
Liquidation means selling collateral, which pushes the price down, which pushes other positions below their thresholds, which causes more selling. In a sharp decline this is self-reinforcing, and it is the mechanism behind almost every violent move in this market.
It is the same reflexivity described in the credit cycle, compressed from months into minutes because the process is automated and the collateral is continuously priced.
Bad debt
If prices fall faster than liquidators can act, a position can end up owing more than its collateral is worth. The shortfall does not vanish — it becomes a hole in the pool, borne by depositors or by whatever reserve the protocol holds.
This is why protocols set conservative collateral factors on volatile assets and why the parameter matters enormously. It is also why the composition of accepted collateral is worth checking: a protocol accepting thinly-traded tokens at generous ratios is carrying risk its depositors may not have priced.
What the visible ledger changes
In conventional markets, leverage is disclosed with a lag and in aggregate. Here, individual positions and their thresholds are public continuously, block by block. That transparency lets risk be measured precisely, and it also means a large, visible cluster of liquidation levels is a target — pushing the price to that level can be profitable for anyone able to move it. Transparency cuts both ways and the second edge is rarely mentioned.