How AAVE Liquidation Works: Must-Know For DeFi Lenders

When the crypto market crashed in 2022, AAVE liquidation became a focal point, emphasizing its importance in the DeFi ecosystem. The automated liquidation of undercollateralized loans served to avert a chain of defaults, saving lenders' money and guaranteeing the platform's viability.

This post will look into the subtleties of AAVE liquidation, including how it works, the dangers and rewards for both lenders and borrowers, and key techniques for navigating this critical component of DeFi financing.

What is AAVE Liquidation?

In essence, AAVE liquidation is a safety mechanism that safeguards lenders' capital inside the AAVE ecosystem. This process occurs when a borrower's loan becomes undercollateralized, meaning the value of the assets pledged as collateral is no longer sufficient to satisfy the existing debt. This usually happens when the value of the collateral assets falls dramatically or the borrowed amount rises.

The risk of liquidation is evaluated by a statistic known as the Health Factor (HF). This figure depicts the relationship between the entire value of a borrower's collateral and the amount of outstanding debt. Simply put, it demonstrates how effectively a loan is secured by assets. A healthy loan will have an HF much higher than 1, while a debt nearing liquidation would have an HF closer to 1.

When a borrower's HF falls below a particular level, which is commonly 1 in AAVE V2, the debt is liquidated. This implies that anybody on the AAVE platform may serve as a liquidator, repaying a part of the borrower's debt in return for a piece of their collateral at a lower cost.

How Does AAVE Liquidation Work?

The AAVE liquidation process unfolds in a series of steps, each playing a crucial role in maintaining the platform's stability and protecting lenders' interests:

1. Health Factor drops below threshold: The first phase in the liquidation process occurs when a borrower's Health Factor (HF) falls below a specified level. This shows that the value of their collateral is no longer adequate to satisfy their existing debt, putting the loan in danger for lenders.

2. Liquidators Identify unhealthy loans: Once a loan is qualified for liquidation, it is exposed to all AAVE platform users. These users, known as liquidators, are constantly monitoring the marketplace for such chances.

3. Liquidators initiate liquidation: A liquidator may start the liquidation process by repaying a part of the borrower's debt. In AAVE V2, liquidators may refund up to 50% of the debt; however, in AAVE V3, the Variable Liquidation Close Factor allows them to repay the whole loan (100%) if the HF falls below a certain level.

4. Liquidators receive collateral at a discount: In return for repaying the debt, the liquidator gets a percentage of the borrower's collateral. However, this collateral is available at a discount known as the liquidation bonus. This payment encourages liquidators to engage in the process, ensuring that unhealthy debts are quickly handled.

The Role of Liquidators And Liquidation Penalties

Liquidators play an important role in the AAVE ecosystem by keeping the platform healthy and shielding lenders from losses. They offer a useful service by accepting the risk of liquidating undercollateralized loans, ensuring that the lending platform runs smoothly.

The liquidation penalty, sometimes known as the liquidation bonus, is a charge applied to the redeemed debt. This cost is subsequently taken from the borrower's collateral, thereby lowering the amount received back. The penalty provides an extra incentive for liquidators to engage in the process by increasing their potential profit.

AAVE V3: Variable Liquidation Close Factor

AAVE V3 introduced the Variable Liquidation Close Factor, which made a substantial modification to the liquidation process. This upgrade increases risk management flexibility and efficiency by allowing liquidators to resolve all undercollateralized loans in a single transaction. Specifically:

• When the HF goes below 1, a liquidator can repay up to 50% of the borrower's obligation.

• But a full liquidation can occur when the HF falls below a lower level, generally about 0.95, allowing a liquidator to repay the entire debt in one go.

Risks And Benefits For DeFi Lenders

AAVE liquidation poses a complicated interplay of risks and benefits for DeFi lenders. Understanding these dynamics is essential for maximizing possible advantages while minimizing potential drawbacks.

Benefits For Lenders

For those offering liquidity on AAVE, liquidation provides numerous benefits that contribute to a safe lending experience. These perks not only encourage lending but also play an important role in the platform's stability.

• Protection of funds: AAVE liquidation provides a safety net for lenders. If a borrower's loan becomes undercollateralized, the liquidation procedure assures that lenders' money is reimbursed, even during unexpected market downturns.

• Earning opportunities: When a loan is liquidated, the liquidator obtains the borrower's collateral at a discounted price, resulting in a possible profit margin. Furthermore, lenders may get a percentage of the liquidation penalty or charge, rewarding their involvement in the process.

• Platform stability: By quickly correcting undercollateralized loans, AAVE liquidation avoids a chain reaction of defaults that may destabilize the platform and destroy user trust.

[CTA: More about Aave (AAVE) Wallet]

Risks For Lenders

While AAVE's liquidation procedure is intended to safeguard lenders, it is vital to recognize that it also involves the following risks:

• Temporary loss of liquidity: During periods of significant market volatility, the value of collateral assets might fall dramatically. If a liquidation happens during such a downturn, lenders may face a temporary shortage of liquidity when their assets are liquidated for a lower price than expected.

• Lower returns: When collateral is sold at a discount during liquidation, the overall amount repaid to lenders decreases, possibly lowering their interest revenue.

• Active monitoring required: Lenders must continuously monitor their loan portfolios and general market circumstances. This requires awareness and a grasp of the elements that might result in liquidations.

How To Avoid Liquidation As A Borrower?

As an AAVE borrower, avoiding liquidation is critical to protecting your assets and maintaining a strong financial position. Some successful ways to achieve that include:

Maintaining a Healthy Health Factor

Monitor your HF regularly to ensure that it stays far higher than the liquidation threshold. You can do this by increasing the collateral on your loan or repaying a part of your debt. Typically, reducing debt is more effective at boosting your HF than acquiring collateral.

Monitoring market conditions

Keep an eye on market changes, since they have a direct influence on the value of your collateral and HF. If you foresee a big reduction in the value of your collateral assets, consider adding extra collateral or returning part of your debt in order to maintain a safe HF.

Setting up alerts

Use AAVE's built-in alerts or third-party technologies to get notifications when your HF is near the liquidation level. This allows you plenty of time to take appropriate action before the liquidation happens.

Utilizing AAVE's risk management tools

AAVE delivers a risk dashboard with vital information about your loan situations and possible dangers. Use this tool to determine your entire risk exposure and make educated choices.

Related content: Risk Management in DeFi Trading

Understanding liquidation thresholds

Be aware that AAVE V3 implemented a lower liquidation threshold (0.95) for complete liquidations than AAVE V2 (usually 1). Consider this in your risk management approach when deciding which protocol version to utilize.

You can considerably lower the danger of liquidation by actively managing your loan position and remaining up-to-date on market circumstances. To further ease your DeFi experience and protect your funds, consider utilizing a reputable wallet like Bitget Wallet, which integrates seamlessly with AAVE and other DeFi platforms.

[CTA: Download Bitget Wallet]