Liquidation

Liquidation is the forced closing-out of a position when a trader's remaining margin, or a DeFi borrower's remaining collateral, can no longer cover the underlying obligation. Exchanges and lending protocols treat it as a last-resort safety mechanism: rather than let losses spiral into debt the trader cannot repay, the system steps in automatically to close the position and protect the platform's solvency.

On centralized and decentralized derivatives exchanges, a liquidation engine tracks each open position against a mark price, a manipulation-resistant reference pulled from multiple markets rather than the last trade on one venue. When equity falls to the maintenance margin threshold, the position is closed at the best available price, and any balance left after fees returns to the trader. If the market moves too fast for an orderly close, an insurance fund absorbs the shortfall; in extreme cases exchanges resort to auto-deleveraging, trimming profitable traders' positions to keep the system solvent. The higher the leverage, the closer this trigger sits to the entry price, so a modest adverse move can wipe out a highly leveraged trade.

DeFi lending works similarly but without a central operator. Protocols such as Aave calculate a health factor from collateral value, borrowed value, and a liquidation threshold; once it drops below 1, anyone can permissionlessly repay part of the debt and claim the borrower's collateral plus a bonus, typically 5 to 15 percent depending on the asset. Faulty oracle price feeds have occasionally triggered mispriced liquidations, sometimes leaving protocols with bad debt when collateral could not be sold fast enough to cover the loan.

In sharply falling markets, many simultaneous liquidations can cascade, with each forced sale pushing prices lower and triggering the next round. Traders manage the risk with lower leverage, larger margin buffers, or a stop-loss order that exits a position before liquidation is reached.