The Liquidation Threshold represents a critical price level or collateralization ratio in leveraged trading or decentralized finance (DeFi) lending, below which an investor’s collateralized position becomes subject to automatic liquidation. It signifies the point where the value of collateral no longer sufficiently covers the outstanding loan or margin.
Mechanism
Operationally, the liquidation threshold is determined by a system’s predefined margin requirements or loan-to-value (LTV) ratios. When the market price of the collateral asset declines, or the loan value increases, real-time monitoring systems continuously assess the position’s health. If the calculated LTV ratio exceeds the threshold, the system automatically triggers a forced sale of the collateral to repay the debt, thereby preventing further losses for the lender.
Methodology
Managing positions relative to the liquidation threshold requires continuous risk assessment and proactive collateral management. Traders employ strategies such as adding more collateral (margin top-up) or reducing their leveraged positions to maintain a buffer above this critical point. For lending protocols, setting appropriate liquidation thresholds and efficient liquidation mechanisms is a core aspect of maintaining system solvency and managing systemic risk in volatile crypto markets.
Quantitative modeling provides the essential framework for translating a DeFi protocol's complex, autonomous code into a legible system of manageable economic risks.
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