A lending protocol has no way to pursue a borrower who walks away. Solvency depends entirely on closing positions before collateral becomes worth less than the debt it secures.
The threshold sits above the debt
Every position carries a liquidation threshold expressed as a ratio between collateral value and outstanding debt. Crossing it makes the position eligible to be closed.
That threshold is set with a buffer, so liquidation triggers while collateral still comfortably exceeds the loan. The gap absorbs price movement during the closing process.
Volatile collateral receives a larger buffer than stable collateral. The parameter reflects how far the asset might move before anyone can act.
Third parties do the work
The protocol does not monitor positions itself, because contracts cannot execute on their own schedule. Independent participants watch for eligible positions and submit the liquidating transaction.
These liquidators repay part of the debt and receive collateral in return, priced at a discount to the market. That discount is their compensation.
The design converts a maintenance problem into a profit opportunity. As long as the discount exceeds transaction and hedging costs, someone will always act.
Oracles determine when the trigger fires
Eligibility depends on a price the contract can read, supplied by an oracle that aggregates external market data. The protocol knows nothing about prices otherwise.
Oracle design therefore controls liquidation timing. Feeds that update on a fixed schedule or only after a threshold movement can lag a fast-moving market by meaningful margins.
Manipulating a thin market to move an oracle has been the basis of repeated attacks. Robust feeds draw from multiple venues and weight by traded volume to make that expensive.
Partial closes limit the damage
Early designs liquidated entire positions at once, which was harsh on borrowers and dumped large amounts of collateral into the market simultaneously.
Most protocols now cap how much of a position can be closed in a single action, restoring the ratio to safety without eliminating the borrower's exposure.
This softens the market impact and gives the borrower a chance to add collateral. It also spreads liquidator activity across more transactions.
Cascades are the failure mode
Liquidations sell collateral, which pushes its price down, which pushes more positions across their thresholds. The mechanism that protects the pool can amplify a decline.
When the discount fails to attract liquidators because the market is falling too fast, positions go unclosed and the pool accrues bad debt. Reserve funds exist to absorb that outcome.
Every parameter in the system is a judgment about this tension. Tighter thresholds protect the pool but liquidate borrowers more often, and the balance is never settled.