Liquidation cascades in DeFi

How small drops become market-wide events

A single liquidation is boring. One borrower fell below their health factor, a liquidator paid off their debt and took their collateral at a small discount, and life moves on. A liquidation cascade is when that exact same event happens to thousands of borrowers within an hour, and all the resulting sell pressure pushes prices down further, which liquidates more borrowers. That feedback loop is the part that hurts.

The mechanism. Lots of borrowers are using ETH as collateral. They are all near the same kind of health factor because they all read the same advice and borrowed roughly the same percent. ETH falls 10%. The borrowers who were sitting closest to the line — say 1.05 — get liquidated. Their ETH collateral is sold into the market by liquidators to repay the debt. That selling adds to the existing pressure, ETH falls another 5%. Now borrowers who were sitting at health factor 1.10 are also under. They get liquidated. More selling. Wash, rinse, repeat.

This isn't theoretical. 2022 alone saw multiple cascades. The collapse of Terra/Luna in May 2022 cascaded through lending markets as borrowers tried to deleverage in a panic. The FTX failure in November dragged ETH and the major caps down 15-25% in days, triggering another round of forced selling on every major lending protocol. The whole DeFi ecosystem lost tens of billions in TVL across these cascades. Cascades repeat because the structural setup is the same every cycle.

There is a brutal second-order effect. Liquidators get paid a bounty (often 5-10% of the liquidated collateral) for executing the liquidation. In a normal market, that's a healthy incentive. In a cascade, it means liquidators are competing to sell the collateral as fast as possible — which accelerates the sell-off. The system is designed to deleverage quickly, even at the cost of price.

Practical defense for retail. One — keep health factors high (above 1.5 minimum, 2+ is safer). Two — don't borrow against highly volatile collateral; ETH is acceptable, a thin altcoin is not. Three — if you're in a leveraged position and you see funding rates spike or stablecoin depeg headlines, deleverage BEFORE the cascade, not during. Once the cascade starts, the network is congested and your transaction may not confirm before liquidation triggers.

Recap: liquidation cascades are forced-selling feedback loops. Small drops liquidate the closest borrowers, that selling drops price further, repeat. Defense: high health factor, stable collateral, and deleverage before the panic — never during.