Liquidation risk: how a collateralized loan gets closed for you

A loan with a tripwire

Lending protocols let you deposit a volatile asset and borrow a stable one against it. The loan stays open as long as your collateral is worth comfortably more than your debt. There is no monthly bill; the risk is entirely about price.

Two settings define the tripwire. The maximum loan-to-value caps how much you can borrow at the start. The liquidation threshold, a slightly higher percentage, sets the point at which the loan can be liquidated. Between them sits your cushion.

Liquidation is carried out by other participants, usually automated programs that watch every open loan and act within seconds of a position becoming eligible. Nobody sends a warning first, and the protocol does not wait for prices to recover. What protects a borrower is the distance between today's price and the liquidation price, and how much of that distance is likely to be used up by volatility, interest and timing.

Worked example: one loan, every number

For illustration, you deposit 10 units of an asset priced at $3,000, so your collateral is worth $30,000. You borrow $15,000 of a stablecoin. The protocol uses a 75% maximum loan-to-value and an 80% liquidation threshold.

Your loan-to-value is $15,000 ÷ $30,000 = 50%. You could have borrowed up to $30,000 × 75% = $22,500, so you have $7,500 of unused borrowing room. The liquidation price and health factor follow from the threshold.

• Health factor = collateral value × liquidation threshold ÷ debt = $30,000 × 80% ÷ $15,000 = 1.6.
• Liquidation price = debt ÷ (units × liquidation threshold) = $15,000 ÷ (10 × 80%) = $1,875.
• Fall to liquidation = 1 − $1,875 ÷ $3,000 = 37.5%.
• A health factor above 1 means the loan is safe from liquidation; at 1 or below, it can be liquidated.

Stress table: health factor as the price falls

Because the debt is fixed in stablecoins, the health factor falls in a straight line with the collateral price. Every 10% drop in price removes 0.16 from this loan's health factor.

The borrow health calculator builds this table for any loan, so you can see in advance which price move takes you to 1.0.

What a liquidation actually costs

Liquidation is not a polite margin call. A liquidator repays part of your debt and receives your collateral worth that amount plus a liquidation bonus. The share of debt that can be repaid in one go is the close factor.

Say the protocol uses a 50% close factor and a 5% bonus, and the price touches $1,875. A liquidator repays $15,000 × 50% = $7,500 and receives $7,500 × 105% = $7,875 of collateral, which is $7,875 ÷ $1,875 = 4.2 units. The $375 bonus is your direct cost, on top of having sold 4.2 units at a low price.

Afterward you hold 5.8 units against $7,500 of debt. At $1,875 your health factor is 5.8 × $1,875 × 80% ÷ $7,500 = 1.16, so the position is open again, but smaller. If the price keeps falling, it can be liquidated again.

Interest quietly moves the line

Borrowing costs interest, and in most lending protocols that interest is added to your debt. Using a 6% borrowing rate held steady for a year, the illustrative debt grows from $15,000 to $15,900.

With the same collateral and price, the health factor slips from 1.6 to about 1.51, and the liquidation price rises from $1,875 to $1,987.50. Nothing in the market changed; the cushion shrank simply because time passed. Variable rates can also jump when a lending market is in heavy use, which tends to coincide with volatile prices.

Leverage loops shrink the cushion

A leverage loop repeats the borrow-and-deposit step: borrow a stablecoin, buy more of the collateral asset, deposit it, borrow again. Each loop increases exposure and debt together.

For illustration, start with $10,000 of an asset, borrow 70% of each new deposit and loop three times, using an 80% liquidation threshold. Exposure reaches about $25,330 against $15,330 of debt, or about 2.53x leverage. The health factor is about 1.32, and a fall of about 24.3% would reach liquidation, compared with 37.5% in the simpler loan above. The leverage calculator shows the same build-up, including gas for each loop.

When the price you are measured by is not the market price

Liquidations are triggered by the protocol's oracle, not by the price you see on a chart. A sudden wick on a thin market, a stale feed or a manipulated price can push a loan under 1.0 briefly. Equally, a slow-moving average can delay liquidations during a real crash. Oracle risk covers how those feeds work.

Network conditions matter too. In a sharp sell-off, gas costs can spike and transactions can queue, so adding collateral or repaying debt may take longer, and cost more, exactly when it matters.

Canadian context

In October 2025, Canadian securities regulators reminded crypto-backed lending platforms that they may be trading or distributing securities and need registration or exemptive relief, and cautioned investors to check before using them. Under the commitments platforms make to regulators, registered crypto trading platforms in Canada are generally not permitted to offer margin, credit or leverage to clients.

On the tax side, CRA's crypto pages do not address DeFi borrowing or liquidation specifically. A liquidation transfers your collateral to someone else, which may be a disposition with a gain or loss; whether profits are capital or business income depends on your facts, as explained in capital vs business income.

Questions to ask before you deposit

• What are the maximum loan-to-value and liquidation threshold for this collateral?
• What is your liquidation price, and how far is it from today's price?
• What liquidation bonus and close factor does the protocol use?
• Is the borrowing rate variable, and how would a higher rate move your liquidation price?
• Which oracle sets the price that triggers liquidation?
• Is a lending platform you use registered, or relying on exemptive relief, in your province?