Liquidation

Liquidation in crypto is the conversion of assets into cash or cash equivalents, most commonly when a leveraged trading position or loan collateral is forcibly sold or closed to cover losses or repay borrowed funds. While the word can broadly mean selling crypto for fiat or stablecoins, in trading and DeFi it usually refers to an automatic, system-driven process.

On margin trading and perpetual futures platforms, traders post margin as collateral to open a position larger than their account balance. If the market moves against the position and the account no longer meets maintenance margin requirements, the exchange will liquidate it, meaning it automatically closes the position to prevent the account from going negative. For example, a trader who opens a high-leverage long on BTC may be liquidated after a relatively small price drop because their collateral buffer is thin. Some venues also charge liquidation fees or use insurance funds to handle extreme moves.

In DeFi, liquidation is typically tied to overcollateralized borrowing. A user deposits collateral, such as ETH, and borrows another asset, often a stablecoin. If the collateral value falls and the loan becomes undercollateralized, the protocol allows liquidators to repay part of the debt and claim collateral, usually at a discount called a liquidation bonus. For instance, a collateralized debt position can be partially liquidated to restore healthy collateral ratios, protecting the protocol from bad debt.

Liquidations are a key risk of leverage and borrowing. They can accelerate volatility, cascade through markets, and turn manageable drawdowns into realized losses. Understanding liquidation thresholds, margin requirements, and collateral ratios helps traders and DeFi users manage risk and keep the broader crypto ecosystem solvent and resilient.