Liquidation and bad debt
Liquidation repays debt by transferring collateral. It can begin before insolvency, and it does not guarantee complete recovery.
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A USEFUL DISTINCTION
Liquidation vs insolvency
A risk-control action is different from a balance-sheet shortfall.
| Look at | Liquidation | Insolvency |
|---|---|---|
| Meaning | A position is reduced or closed under defined rules. | Recoverable assets are insufficient for obligations. |
| When it can occur | Often before equity reaches zero. | When the available asset value is below debt or claims. |
| Mechanism | Collateral is seized or sold in return for repayment. | Losses remain and must be allocated or resolved. |
| Dependencies | Price feeds, incentives, execution, market depth, and timing. | Recoverable value, obligations, priority, and recovery arrangements. |
| Relationship | Attempts to limit shortfalls; cannot guarantee prevention. | Can remain after incomplete or delayed liquidation. |
Aave Labs · Health Factor & Liquidations ↗Checked 13 Nov 2026Aave documentation contributors · Aave V3 Overview ↗Checked 13 Nov 2026Bank for International Settlements, Bulletin 57 · DeFi lending: intermediation without information? ↗Checked 13 Nov 2026Aave Labs · Borrow Tokens ↗Checked 13 Nov 2026ethereum.org contributors · Smart contract security ↗Checked 13 Nov 2026Bank for International Settlements, Working Paper 1066 · The Technology of Decentralized Finance (DeFi) ↗Checked 13 Nov 2026
THE KEY DISTINCTION
What to carry forward
“Liquidatable” and “underwater” are not synonyms. A healthy liquidation mechanism can act while the borrower still has positive equity.
MAKE IT CONCRETE
A worked perspective
$800 debt against $900 collateral can be liquidatable under an illustrative 80% threshold while still having $100 gross equity before penalties and costs.
Try the labFollow the underlying mechanisms
Collateral and borrowing capacity
Collateral is a recovery asset. Its quantity, market value, liquidity and permitted use all affect how much credit it can support.
How crypto systems fail
Failures occur at distinct layers: keys, contracts, economic assumptions, operators and connections. A useful risk map follows the assets through each.