Decentralized finance (DeFi) has revolutionized the way people borrow and lend digital assets, with platforms like Aave leading the charge. As one of the most trusted lending protocols in the crypto space, Aave enables users to borrow cryptocurrencies by locking up collateral—without intermediaries. However, one critical risk borrowers face is liquidation, a safety mechanism designed to protect the system but potentially costly for individuals.
Understanding how liquidation works on Aave is essential for both lenders and borrowers. This guide breaks down the mechanics of liquidation, explains key concepts like health factor and liquidation bonus, and offers practical insights to help you manage your DeFi loans more effectively.
What Is Liquidation on Aave?
Liquidation occurs when a borrower’s loan becomes undercollateralized, meaning the value of their deposited collateral drops below the required threshold to back their debt. To maintain solvency, Aave allows third parties—called liquidators—to step in and repay part of the loan in exchange for a discounted portion of the borrower’s collateral.
This process protects lenders from losses and ensures the protocol remains financially sound, even during periods of high market volatility.
👉 Discover how to monitor your loan health and avoid unexpected liquidations with real-time tools.
Understanding the Health Factor
The health factor (HF) is the core metric that determines your risk of liquidation. It represents the ratio between the value of your collateral and your outstanding debt, adjusted for asset-specific risk parameters.
Aave Health Factor Formula:
Health Factor = (Total Collateral Value × Liquidation Threshold) / Total Borrowed Value- When HF > 1: Your position is safe.
- When HF ≤ 1: Your loan becomes eligible for liquidation.
Each supported asset on Aave has a predefined liquidation threshold, which reflects its volatility and risk level. For example:
- ETH might have a threshold of 80%, meaning you can borrow up to 80% of your ETH’s value before nearing liquidation.
- More volatile tokens like UNI may have lower thresholds (e.g., 65%).
This means even if your total collateral exceeds your debt, you could still be liquidated if the threshold is breached due to price swings.
How Does Liquidation Work?
When a borrower’s health factor falls below 1, their position is open to liquidation. Here's how the process unfolds:
- Detection: A liquidator (often an automated bot) identifies an undercollateralized position.
- Partial Repayment: The liquidator repays up to 50% of the borrower’s outstanding debt.
- Collateral Claim: In return, they receive a corresponding amount of collateral at a discount, known as the liquidation bonus.
- Execution: The transaction is executed on-chain via smart contracts, instantly updating both parties’ balances.
For example:
- If you borrow DAI using ETH as collateral, a drop in ETH’s price could trigger liquidation.
- A liquidator repays part of your DAI debt and receives ETH at a discount (e.g., 5–9%), profiting from the spread.
This mechanism incentivizes quick action and helps stabilize the protocol during market downturns.
Liquidation Bonus: Incentive for Risk-Takers
The liquidation bonus varies by asset and is set by Aave based on risk profiles. Higher bonuses are assigned to more volatile assets to attract liquidators despite increased price risk.
| Asset | Typical Liquidation Bonus |
|---|---|
| ETH | 5% |
| BTC | 5% |
| UNI | 9% |
| Stablecoins | 5–8% |
💡 Example: Bob borrows 5 ETH worth of DAI using 10 ETH as collateral. If ETH’s price drops sharply and his health factor dips below 1, a liquidator can repay 2.5 ETH worth of DAI and receive 2.625 ETH (including 5% bonus), netting a profit if they sell quickly.
While this rewards liquidators, it means borrowers lose more than just their debt—they forfeit valuable collateral at fire-sale prices.
Manual vs Automated Liquidation
There are two paths through which liquidation can occur:
🔹 Automated Liquidation
- Performed by bots or professional liquidators scanning the blockchain.
- Fast and efficient, often occurring within seconds of HF dropping below 1.
- Most common method on Aave.
🔹 Manual Self-Liquidation
- Borrowers voluntarily repay part of their loan to increase their health factor.
- Allows control over timing and execution price.
- Useful during minor dips to avoid automated takeovers at unfavorable rates.
Proactive borrowers often use alerts or DeFi dashboards to monitor their positions and act before automation kicks in.
👉 Stay ahead of market swings with advanced monitoring tools that track your loan status in real time.
Frequently Asked Questions (FAQ)
Q: Can I avoid liquidation entirely?
A: Yes, by maintaining a conservative loan-to-value ratio, using stable or low-volatility collateral, and actively monitoring your health factor during volatile markets.
Q: How fast does liquidation happen?
A: Typically within seconds once HF < 1, especially during flash crashes or high volatility events.
Q: Do I lose all my collateral when liquidated?
A: No—only enough collateral to cover up to 50% of your debt plus the bonus is seized. However, repeated liquidations can erode your holdings significantly.
Q: Can stablecoin loans be liquidated?
A: Yes, even if you borrow stablecoins, if the value of your collateral drops (e.g., ETH used to borrow DAI), you’re still at risk.
Q: Are there tools to help prevent liquidation?
A: Yes—platforms like WEHODL simplify health monitoring by showing your safety margin, indicating how much prices can fall before liquidation triggers.
Q: What happens if no one liquidates my position?
A: While rare, if no liquidator acts, your position remains undercollateralized until either recovery or eventual forced settlement by governance mechanisms (in extreme cases).
Key Risks and Best Practices
Liquidation isn’t just theoretical—it happens regularly during crypto market swings. Consider these strategies to protect yourself:
- Over-collateralize: Borrow less than your maximum limit to create a buffer.
- Diversify Collateral: Use multiple asset types to reduce exposure to single-asset crashes.
- Set Price Alerts: Use DeFi dashboards or apps to get notified when HF approaches danger zones.
- Use Stop-Loss Strategies: Some platforms offer integrations that auto-repay loans when thresholds are hit.
Remember: High leverage increases reward potential but also magnifies risk. Smart borrowing means respecting volatility.
Final Thoughts
Liquidation is a fundamental feature of Aave’s risk management framework. While it protects lenders and maintains protocol integrity, it poses real financial risks for borrowers who aren’t vigilant.
By understanding how health factor, liquidation thresholds, and bonuses work, you can make informed decisions and avoid costly surprises. Whether you're new to DeFi or an experienced user, staying educated and proactive is your best defense against unexpected losses.