DeFi Liquidation Mechanics: How Cascades Happen and How to Survive Them

November 2022. Terra collapsed.March 2025. ETH flash crash.Both triggered liquidation cascades worth billions.

If you're using leverage in DeFi, understanding liquidation mechanics isn't optional — it's survival.

The Health Factor

Your position's survival depends on one number: the health factor.

```

Health Factor = (Collateral Value × Liquidation Threshold) / Debt Value

```

• HF > 1.0 = Safe (for now)
• HF = 1.0 = Liquidation triggers
• HF < 1.0 = Position is being liquidated

Example:

• Collateral: 10 ETH at $2,500 = $25,000
• Liquidation Threshold: 80%
• Debt: $18,000 USDC

Health Factor = ($25,000 × 0.80) / $18,000 = 1.11

You're safe... until ETH drops 10%.

Liquidation Threshold vs LTV

These are different and confusion kills portfolios.

Loan-to-Value (LTV): Maximum you can borrow. For ETH on Aave, typically 80%.

Liquidation Threshold: Point at which liquidation triggers. For ETH, typically 82.5%.

The gap between them is your safety margin. Borrowing at max LTV leaves almost no room for price drops.

The Cascade Effect

Liquidations don't happen in isolation. Here's the death spiral:

1. Price drops 5%
2. Overleveraged positions hit HF < 1
3. Liquidators sell collateral to repay debt
4. Selling pressure drops price further
5. More positions hit HF < 1
6. Repeat until selling exhausts or prices stabilize

During cascades, prices can temporarily drop 30-50% below fair value.

Liquidation Penalties

Getting liquidated isn't just bad — it's expensive.

On a $100K position, losing 8-13% to penalties hurts more than the price move itself.

Defense Strategies

Conservative LTV

Never borrow more than 50-60% of max LTV. Yes, capital inefficient. Also keeps you solvent.

Automated Deleveraging

Tools like DeFi Saver auto-repay debt when HF drops. Costs a fee but saves your position.

Staggered Positions

Instead of one large position, multiple smaller ones at different liquidation points.

stETH as Collateral

If borrowing against ETH, use stETH. Earns yield while collateralized, offsetting borrowing costs.

Monitor Actively

Set alerts for HF dropping below 1.3. Act before it's urgent.

When NOT to Use Leverage

• High volatility periods (post-ETF decisions, major upgrades)
• When you can't monitor daily
• With assets that can depeg (not just stablecoins — LSTs too)
• If losing the position would materially hurt you

Leverage amplifies gains. It also amplifies losses. And in DeFi, the margin for error is zero.