What happens when a crypto loan is liquidated?

Who liquidates, and why

On Aave, a loan can be liquidated once the borrower's health factor falls below 1.¹ Liquidation is permissionless: anyone can start one once a loan qualifies.¹

The liquidator repays debt on the borrower's behalf. In return, it gets the same value of the borrower's collateral, plus a liquidation bonus.¹ Aave's glossary calls the bonus an incentive for liquidators to buy collateral from loans that are under-collateralised.⁴ The bonus comes out of the borrower's collateral, so it is the borrower's cost.¹

Aave says liquidations are highly competitive. Liquidators usually run custom bots to watch loans, react to new oracle prices and be first to act.¹

How much can go at once

Many apps do not sell all the collateral at once. Compound's older version, v2, calls the limit the close factor: the share of a loan that can be repaid in a single liquidation.⁵

Aave's help pages, read in October 2026, give the rules for Aave V3.^1,6

• Up to 50% of the debt can be liquidated when the health factor is above 0.95 and both the collateral and the debt are worth at least $2,000.¹
• Up to 100% can be liquidated when the health factor is 0.95 or below, or when either the collateral or the debt is worth less than $2,000.¹
• No dust. A partial liquidation must leave at least $1,000 of both collateral and debt; otherwise the whole loan must be cleared.¹

Designs change. In December 2025, Aave described the liquidation design of its V4 version, saying the fixed close factor often over-liquidated borrowers.⁷ In V4, a liquidator can repay only enough to bring the health factor back to a target set by governance, and the bonus gets bigger as the health factor gets lower.⁷ V4 went live on Ethereum on 30 March 2026.⁸

The bonus in numbers

The sum is simple: collateral taken = debt repaid × (1 + bonus).^5,1 Compound v2's documentation says its "liquidation incentive" is multiplied by the debt repaid to work out how much collateral can be taken.⁵

It gives an example. With an incentive of 1.08, liquidators get an extra 5.2% of collateral for each unit of debt they repay, and another 2.8% goes to the protocol's reserves.⁵

Not every app works this way

Compound III, the newer version, does it differently. Anyone can call a function that hands an under-collateralised loan to the protocol. The protocol takes all the borrower's collateral and credits its value, minus a penalty, in the main asset. That clears the debt, and anything left over stays with the borrower.⁹ The protocol pays for this from its reserves, and later sells the collateral to buyers at a discount.⁹

In 2020, Maker's vaults were liquidated through auctions, where the bidders, called keepers, often ran bots.³ In 2024, MakerDAO renamed itself Sky.¹⁰ Module 22 explains how its auctions work.

Prices come from oracles

A liquidation is only as fair as the price that triggers it. Each Aave market gets its prices from an oracle contract chosen through Aave's governance.¹¹ Liquidators act on those oracle prices.¹ Module 15 explains oracles and how they can be manipulated.

When liquidations feed on themselves

In 2023, the FSB said that automatic liquidation of collateral is a main reason why selling spirals in DeFi can be so violent.² If collateral is sold into a stressed market with little liquidity, it pushes prices down further, which can set off more liquidations.² In traditional finance, it said, central clearing houses and market circuit breakers can calm this; DeFi has neither.²

The 2022 BIS bulletin showed liquidations on Aave peaking when ether's price swung most.¹² It said collateral values had sometimes fallen so fast that there was no time to unwind loans, and lenders lost money.¹² It added that liquidators may hold back when prices are very volatile, because the collateral they take could lose value before they can sell it.¹²

What happened on 12 and 13 March 2020

Maker's own post-mortem, published on 1 April 2020, describes what happened to its system.³

• The crash. Over 36 hours, ether, bitcoin and the wider crypto market lost over 50% of their value.³
• The jam. The Ethereum network became congested and fees spiked. Vault owners struggled to add collateral in time, and the keepers that bid in Maker's liquidation auctions ran short of DAI.³
• The liquidations. About 1,200 vaults were liquidated. Some auctions were won with bids of almost zero.³
• The hole. That left a shortfall of about 5.4 million DAI. Under Maker's design, MKR holders covered it: new MKR was created and sold, diluting their holdings.³

Maker said there was not enough evidence to say whether the zero bids were an attack.³