Detailed Instructions

A liquidation is triggered when a borrower's Health Factor (HF) falls below a protocol-defined liquidation threshold, typically 1.0. This occurs when the value of the collateral falls or the borrowed debt increases, reducing the safety margin. Protocols like Aave and Compound monitor this in real-time via on-chain oracles.

• Sub-step 1: Monitor Position Health: Continuously check the HF using the formula: HF = (Collateral Value * Liquidation Threshold) / Borrowed Value.
• Sub-step 2: Identify Trigger Event: A liquidation is callable by any user when HF < 1. For example, on Ethereum Mainnet, calling Aave V3 Pool function liquidationCall() for address 0x87870Bca3F3fD6335C3F4ce8392D69350B4fA4E2.
• Sub-step 3: Calculate Shortfall: Determine the liquidation bonus (e.g., 5-15%) the liquidator will receive, which acts as an incentive and a penalty on the borrower.

Tip: Use a blockchain explorer or subgraph to track positions nearing liquidation for potential opportunities.

Detailed Instructions

The liquidator repays part or all of the borrower's outstanding debt in exchange for the underlying collateral, plus a liquidation bonus. This creates a Dutch auction or fixed-discount model. The key economic incentive is the profit from the discount, while the penalty disincentivizes risky borrowing.

• Sub-step 1: Assess Profitability: Calculate potential profit considering gas costs, slippage, and the bonus. For a debt of 100 DAI, with a 10% bonus, you receive ~110 DAI worth of collateral.
• Sub-step 2: Execute Liquidation Call: On-chain, the liquidator calls the liquidation function. Example for Compound V2:

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Comptroller(0x3d9819210A31b4961b30EF54bE2aeD79B9c9Cd3B).liquidateBorrow(address borrower, uint repayAmount, address cTokenCollateral)

• Sub-step 3: Handle Collateral: The seized collateral is sent to the liquidator's address. The repaid debt is burned from the protocol.

Tip: Use flash loans from protocols like Balancer (0xBA12222222228d8Ba445958a75a0704d566BF2C8) to fund large liquidations without upfront capital.

Detailed Instructions

The liquidation penalty is applied by giving the liquidator more collateral than the debt repaid. This penalty is a critical economic lever, protecting the protocol's solvency by ensuring over-collateralization. The borrower's position is partially or fully closed.

• Sub-step 1: Deduct Penalty: The protocol automatically deducts the bonus from the borrower's collateral. For instance, a 10% penalty on a 1 ETH collateral seizure means the borrower loses 1.1 ETH for every 1 ETH of debt cleared.
• Sub-step 2: Update Account State: The borrower's debt is reduced, and their Health Factor is recalculated. If the HF is still below 1, the position may face further liquidation.
• Sub-step 3: Handle Residual Debt/Collateral: Any remaining debt must still be repaid by the borrower. Excess collateral may be returned if the liquidation only covered a portion (e.g., up to 50% of the collateral in one tx).

Tip: Borrowers should monitor their HF closely and add collateral or repay debt preemptively to avoid these penalties.

Detailed Instructions

The entire lifecycle is designed to align incentives. The liquidation bonus incentivizes liquidators to act as a decentralized policing force, while the penalty discourages excessive risk-taking by borrowers. This mechanism maintains the protocol's overcollateralization ratio and prevents bad debt.

• Sub-step 1: Protocol Safety: The primary goal is to protect depositors. Liquidations convert risky, undercollateralized debt into safe, solvent positions.
• Sub-step 2: Market Efficiency: Competitive liquidators ensure positions are liquidated near the threshold, minimizing the systemic risk of a cascade.
• Sub-step 3: Parameter Tuning: Governance (e.g., token holders) can adjust the liquidation threshold and bonus via proposals. For example, a DAO vote might change the bonus from 5% to 8% to increase liquidator participation during high volatility.

Tip: Understanding these economics is key for all participants: borrowers manage risk, liquidators seek profit, and depositors rely on the system's stability.

Detailed Instructions

First, you must gather the protocol's specific liquidation parameters. These are the hard-coded rules that trigger a liquidation and determine its financial outcome. This is a foundational step, as all subsequent calculations depend on these values.

• Sub-step 1: Locate the protocol's documentation or smart contracts. For example, examine the LiquidationModule.sol contract on Ethereum mainnet at 0x....
• Sub-step 2: Extract the key constants. These typically include the liquidation threshold (e.g., 85%), the liquidation penalty (e.g., 10% of the borrowed amount), and the liquidation incentive or bonus for liquidators (e.g., 5% of the seized collateral).
• Sub-step 3: Note the price oracle source. Identify the contract address (e.g., Chainlink ETH/USD feed at 0x5f4eC3Df9cbd43714FE2740f5E3616155c5b8419) and the required health factor formula, often (Collateral Value * Collateral Factor) / Borrowed Value.

Tip: These parameters are not universal. Aave, Compound, and MakerDAO all have different models, so always verify against the specific protocol you are analyzing.

Detailed Instructions

With the parameters defined, calculate the health factor (HF) for a specific user position. A health factor below 1.0 indicates the account is eligible for liquidation. The liquidation shortfall is the monetary value needed to bring the HF back to a safe level (e.g., 1.0).

• Sub-step 1: Fetch the user's position data. Use the protocol's public getUserAccountData function. For a user at address 0xUser..., you might call:

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const userData = await lendingContract.getUserAccountData('0xUser...');
// Returns totalCollateralETH, totalDebtETH, healthFactor, etc.

• Sub-step 2: Manually verify the HF. Use the formula: HF = (Total Collateral in USD * Liquidation Threshold) / Total Debt in USD. If the oracle price of ETH is $3,000, 10 ETH collateral with an 85% threshold and $20,000 debt gives HF = (10 * 3000 * 0.85) / 20000 = 1.275.
• Sub-step 3: Calculate the shortfall. If HF < 1.0, the shortfall is Total Debt - (Total Collateral * Liquidation Threshold). For a debt of $22,000 and collateral worth $20,000 at 85% threshold, the shortfall is 22000 - (20000 * 0.85) = $5,000.

Tip: The shortfall represents the minimum value a liquidator must repay to receive a reward.

Detailed Instructions

This step quantifies the economic transfer. The liquidation penalty is a fee applied to the borrower's debt, increasing the amount to be repaid. The liquidation incentive is the reward, often a discount on collateral, granted to the liquidator for repaying the debt.

• Sub-step 1: Determine the maximum liquidatable debt. Protocols often limit liquidation to a portion of the debt (e.g., up to 50% in one transaction). Calculate maxLiquidationAmount = debt * liquidationCloseFactor.
• Sub-step 2: Calculate the total repayment cost for the liquidator. This is the debt amount being repaid plus a potential liquidation penalty. For a $10,000 debt slice with a 10% penalty: repaymentCost = 10000 * (1 + 0.10) = $11,000.
• Sub-step 3: Calculate the collateral seized by the liquidator. The liquidator receives collateral worth the repayment cost, plus an incentive bonus. Using a 5% bonus: collateralSeizedValue = repaymentCost * (1 + 0.05) = $11,550. If collateral is ETH at $3,000, they receive 11550 / 3000 = 3.85 ETH.

Tip: The borrower's net loss is the penalty (the extra debt), while the liquidator's profit is the incentive bonus, minus gas fees and slippage.

Detailed Instructions

The final step is to stress-test the calculations. Incentive sufficiency is critical for protocol safety; if the reward is too low, liquidators may not act, risking systemic insolvency. Model different market conditions.

• Sub-step 1: Factor in execution costs. A liquidator's net profit is Incentive Bonus - Transaction Gas Cost - Slippage on DEX Swaps. On Ethereum, a complex liquidation can cost 0.1 ETH ($300) in gas. If the incentive is only $200, the action is unprofitable.
• Sub-step 2: Model high gas price and volatile oracle scenarios. Use historical data (e.g., from etherscan.io/gastracker) and oracle latency. Script a simulation where the price drops 5% between the oracle update and the liquidation tx.
• Sub-step 3: Calculate the minimum profitable health factor. Rearrange formulas to find the HF threshold where Liquidator Profit > 0. This defines the effective liquidation threshold, which may be higher than the protocol's parameter due to these costs.

Tip: Protocols may adjust incentives dynamically. Monitor governance proposals for changes to penalty and bonus percentages to keep the system secure.