Collateral Ratios and Liquidation Mechanics
The previous lesson showed that lending protocols let borrowers deposit collateral and borrow a different asset against it. This lesson explains the rule that makes that safe for the protocol (and risky for you if you misjudge it): over-collateralization. Unlike a traditional mortgage, where you might borrow 80-95% of an asset's value, DeFi lending protocols require you to deposit more value than you borrow, because there's no credit check, no recourse to sue a defaulting borrower, and no human underwriter — the only thing standing between the protocol and a bad debt is the collateral itself, which must be enough to cover the loan even after some price movement.
Two numbers define how this works. The first is maximum loan-to-value (LTV) — the largest percentage of your collateral's current value you're allowed to borrow. If a protocol sets ETH's max LTV at 80%, depositing $10,000 of ETH lets you borrow up to $8,000 of another asset. The second, and more important for risk management, is the liquidation threshold — a higher percentage than the max LTV, representing the point at which your position becomes eligible for liquidation. The gap between your max LTV and your liquidation threshold is not a buffer you're meant to use casually; it's a safety margin against normal price volatility. When your borrowed amount, divided by your current collateral value, crosses the liquidation threshold — because the collateral's price fell, the borrowed asset's price rose, or both — the protocol allows a third party called a liquidator to repay part of your debt and seize a corresponding portion of your collateral, usually at a discount to its market price, which is the liquidator's incentive to do this work. You, the borrower, also typically pay a liquidation penalty on top of losing the discounted collateral — this is not simply "the loan gets called," it's a punitive event you want to avoid entirely.
It helps to think of liquidation as an automatic, code-enforced margin call with no grace period and no phone call warning you first. The smart contract doesn't know or care that you're asleep, on a flight, or simply not checking your phone — if the math crosses the threshold, any liquidator (often a bot specifically built to watch for this) can execute the liquidation the moment it becomes profitable to do so.
Worked Example
You deposit $10,000 of ETH as collateral, with the protocol setting ETH's max LTV at 80% and its liquidation threshold at 85%. You borrow the maximum allowed, $8,000, in a stablecoin. Your current "LTV" right now is $8,000 ÷ $10,000 = 80% — right at the ceiling you were permitted to borrow, but still 5 percentage points below the 85% liquidation threshold.
Now suppose ETH's price falls, and your collateral — still the same quantity of ETH — is now worth only $9,400 instead of $10,000. Your borrowed amount hasn't changed ($8,000), but your LTV has risen: $8,000 ÷ $9,400 ≈ 85.1%, which has just crossed the 85% liquidation threshold. A liquidator can now step in, repay part of your $8,000 debt, and seize the equivalent value of your ETH collateral at a discount (commonly 5-10% below market price, depending on the protocol), plus you're charged a liquidation penalty on top. This happened from only a 6% drop in ETH's price — a move that can happen within a single volatile day in crypto markets — because you had borrowed right up against the maximum allowed LTV, leaving almost no buffer between your starting position and the liquidation threshold.
Compare this to a borrower who deposited the same $10,000 of ETH but only borrowed $4,000 (a 40% LTV instead of the maximum 80%). For that borrower's position to reach the 85% liquidation threshold, ETH's price would need to fall all the way to around $4,706 of collateral value — a drop of more than 52% — a far larger, far less likely move than the 6% that liquidated the first borrower.
Exercise
Using the same sample position as the worked example — $10,000 deposited, 80% max LTV, 85% liquidation threshold — calculate the exact price drop percentage in the collateral asset that would trigger liquidation if you borrow the full $8,000 maximum. Show your work: find the collateral value at which $8,000 equals 85% of that value, then calculate the percentage drop from the original $10,000.
Now redo the same calculation assuming you only borrow $4,000 (50% of the max allowed LTV) instead of the full $8,000. Calculate both the dollar buffer and the percentage price drop needed to reach liquidation in this second scenario, and compare it directly to your first answer. Write one sentence stating how many times larger a price move it would take to liquidate the conservative borrower compared to the maximum-LTV borrower.
Recap
- DeFi loans require over-collateralization because there's no credit check or legal recourse — collateral value, not trust, backs every loan.
- Max LTV sets how much you can borrow; the liquidation threshold (always higher) is the point where a liquidator can seize your collateral at a discount plus a penalty.
- Borrowing well below the maximum LTV creates a much larger price-movement buffer before liquidation becomes possible — a small reduction in borrowed amount can dramatically increase your safety margin.