If you are new to DeFi, you may be wondering how protocols ensure that their users always safely get back the funds that they loan out.
Most lending protocols in DeFi use the same structure - Overcollateralized loans.
This means that borrowers will need to lock collateral of their own in the system to be able to borrow funds. The value of the collateral needs to be superior to that of the loan.
For example, Alice can borrow 100 USDC if she locks $150 worth of ETH in the protocol. If the collateral’s value (in this case ETH) falls under the value of her loan, it will be sold against the asset which she borrowed (in this case USDC). The lender will be repaid in full by the protocol. This is called liquidation.
TL;DR - If Alice’s ETH collateral value drops close to $100 USDC, the protocol will automatically sell it to repay the user that lent the $100 USDC to Alice.
Liquidation happens prior to the collateral value going under the loan value. 80% is usually the maximum threshold. We call that LTV (Loan To Value). This means, if the loan value is over 80% of the collateral value, the collateral will automatically be liquidated.
Liquidations are usually executed by liquidation bots that monitor the protocol. They earn a small fee by doing so.