How Leverage and Liquidation Work

Liquidation is the system-enforced closure of a position or the sale of collateral when that collateral is insufficient to support an open debt or leveraged position. It is known as “tasfiye” in Turkish. It differs from a standard sell order placed by the user at will. Trigger prices, collateral types, and closure methods vary by platform; no single formula provides accurate results for all products.

How does leverage affect collateral?

Leverage allows you to gain exposure to the price movements of a position larger than your deposited collateral. Hypothetically, imagine opening a $10,000 linear long position with $1,000 in collateral. If the asset price drops by 1%, a loss of approximately $100 occurs, excluding fees and other factors. This loss represents 1% of the position but 10% of the initial margin.

This example does not mean you can necessarily wait until the price drops exactly 10% at 10x leverage. Systems typically require a minimum amount of collateral to maintain a position. Maintenance margin requirements, fees, funding, and pricing rules mean liquidation can occur earlier. As the position size increases, collateral tiers may also change.

Initial and maintenance margin

Initial margin is the amount required to open a position. Maintenance margin is the minimum level that must be maintained for the position to remain open. When your collateral balance approaches this requirement due to losses and deductions, the risk of liquidation increases. Having a sufficient balance initially does not guarantee that the position will remain safe on its own later.

For instance, consider a hypothetical $500 maintenance requirement for a $10,000 position. If the $1,000 collateral drops to $600, only a $100 buffer remains. Since requirements can change along with the position value in real systems, this simple example does not provide an exact liquidation price. One must rely on the assumptions in the platform’s calculator and the specific contract rules.

Difference between isolated and cross margin

In isolated margin, the balance allocated to a specific position is used. In cross margin, the account’s shared supported collateral can support multiple positions. A cross-structure can cover a position’s temporary loss with other balances; however, it can also cause that position to affect a larger portion of the account. Generalizations like “cross is safer” or “isolated always limits losses to this amount” ignore specific product rules.

Some platforms offer an automatic margin top-up option. When enabled, more balance than initially allocated may be transferred to the position. If the collateral itself is a crypto asset, its price can also drop, reducing its security value. In systems using multiple collateral types, different haircuts (valuation discounts) may apply to each asset. The total asset value seen in the account may not be the same as the available collateral.

Why do chart prices and liquidation prices look different?

Derivative platforms may trigger liquidation using the mark price instead of the last traded price. The mark price is created using indexes from different markets and contract-specific calculations. The goal is to reduce the impact of a single unusual trade price. However, the calculation used varies by platform; it is essential to know which price is displayed on the chart.

For example, if the last price is 100, the mark price is 99, and the liquidation condition is tied to the mark price, looking only at the last price chart is insufficient. If your stop order tracks a different price, the two mechanisms may trigger at different times. Therefore, having a stop order does not definitively prevent liquidation. Even if the order is triggered, the execution price and liquidity in a fast market affect the outcome.

How does liquidation occur in DeFi loans?

In DeFi, a borrower typically provides collateral of higher value than their debt. This ratio can deteriorate when collateral value drops or debt interest accumulates. In systems like Aave, the health factor summarizes this relationship. In a single-collateral example, the factor is 1.5 for $8,000 in collateral, a 75% liquidation threshold, and $4,000 in debt.

If the collateral value drops to $5,000, the same simple calculation results in 0.9375, and the position may become eligible for liquidation. A liquidator can repay the debt and receive an equivalent amount of collateral plus an additional share (bonus) set by the protocol. The amount of debt to be closed and the size of the bonus vary by market. This process does not use the same infrastructure as a centralized exchange closing a futures position.

Does adding collateral solve every problem?

Adding collateral or repaying part of the debt can improve the ratio. However, performing these actions requires sufficient available balance, the correct asset, and transaction fees. Network congestion, platform outages, or transfer wait times can delay intervention. If price movement is extremely fast, liquidation may occur before the transaction is completed.

Adding extra collateral also means allocating more money to the same risk. It does not eliminate the position’s fundamental risk. Reducing debt versus increasing collateral are economically different choices; both should be recalculated afterward. Notifications or emails from the system are merely warnings, not automatic protection mechanisms. An approach based on tracking the liquidation threshold at the last second is prone to operational issues.

How to read the account after liquidation

In the transaction history, check the closed amount, the price used, the liquidation fee, and the remaining balance separately. Partial liquidation does not mean the entire position is closed. The margin ratio of the remaining position may change again. Funding and other fees may also be reflected in the final result. Simply comparing the entry and exit prices on the chart may not show the total cost.

The presence of an insurance fund on a platform does not mean user collateral is a protected deposit. The purpose and scope of this fund are defined in the platform rules. In extraordinary conditions, mechanisms like auto-deleveraging (ADL) may also exist. It is necessary to understand the product’s loss and closure rules before opening a trade; a general crypto guide does not replace the specific contract terms of a platform.

A point not to be confused with spot buying

When the price of an asset you bought on the spot market without using debt or leverage drops, a classic collateral liquidation does not occur solely because of that drop. The market value of your asset may still decrease significantly. Conversely, using that same asset as collateral for a loan or in a margin account can trigger the liquidation mechanism. To understand the source of risk, look at the product you are holding it in, not just the name of the asset.

Sources

• Aave: liquidation of debt positions
• Coinbase: margin and clearing mechanism
• Coinbase: mark price and position calculations