What Are Liquidations in Crypto and How Do They Happen?

What Are Liquidations in Crypto?

A crypto liquidation is the forced closing or settlement of a position because there is no longer enough collateral to meet the minimum requirement. This happens mainly with futures and perpetuals, but liquidations can also happen with DeFi loans.

With futures and perpetuals, you put up margin: collateral that lets you open a larger position than your own deposit. This is called trading with leverage. As long as your margin stays high enough, your position stays open. If it drops too far because of a price move, a crypto exchange or trading platform can automatically close your position fully or partially.

The level you need to stay above is called the maintenance margin. Simply put, this is the minimum amount of collateral needed to keep your position open. If your available balance falls below that, the platform steps in to prevent losses from getting worse.

With a DeFi loan, it works a little differently. You borrow crypto or another token and lock up collateral. If that collateral becomes too low in value compared to your debt, a liquidator can pay off part of your debt. In return, that liquidator receives part of your collateral, usually with a liquidation bonus. So a liquidator is a person or an automated system that settles undercollateralized loans.

Important: a liquidation is not the same as just selling your crypto on the spot market. With derivatives, a contract position is forced closed. With a DeFi loan, debt is repaid and collateral is claimed.

Key Takeaways

• A crypto liquidation happens when there is too little collateral left to safely keep a position or loan open.
• With futures and perpetuals, a position can be closed once margin falls below the maintenance margin.
• Leverage makes a position more sensitive to price moves in the wrong direction.
• With DeFi loans, a liquidator can repay debt and receive collateral with a liquidation bonus.
• Large numbers of liquidations can amplify price moves in the crypto market.

How Does a Crypto Liquidation Work?

A crypto liquidation usually starts with a leveraged position. You put up part of the total position value as margin. That lets you open a larger futures or perpetual position with a relatively small deposit.

During trading, the platform keeps track of how much margin you still have left. As long as that stays high enough, your position remains open. If the price moves against you, your losses grow and your available margin drops. If it falls below the required maintenance margin, the platform can automatically liquidate your position.

Many platforms look at the mark price for this. That is not simply the last traded price, but a calculated price that is meant to better reflect what the contract is worth at that moment. This helps the platform avoid a single unusual or temporary trade from triggering a liquidation right away.

Example: Suppose you open a long position with leverage. If the mark price drops sharply, your losses get bigger. If there is eventually not enough margin left to meet the maintenance margin, the platform can automatically close your position.

The liquidation price is not always fixed. If you add extra margin or adjust your position, for example, that price can change.

Are you using cross margin? Then multiple positions share the same available balance. If one position goes deep into the red, that can also affect how much margin is left for your other positions.

A platform also does not always have to close a position all at once. It may first cancel open orders or reduce part of the position. How a liquidation is carried out exactly depends on the crypto exchange, the contract, and the margin mode.

With DeFi loans, it works a bit differently. There, platforms often look at the health factor. This is a number that shows how safe your loan still is. On Aave V3, a loan can be liquidated once the health factor drops below 1. If the value of your collateral falls or the value of your debt rises, that health factor can drop and a liquidation gets closer.

What Is the Difference Between Long and Short Liquidations?

A long liquidation and a short liquidation both happen when there is no longer enough margin left to keep a position open. The main difference is the direction the price moves.

With a long position, you expect the price to go up. If the price drops sharply instead, your losses grow and your available margin gets smaller. If it falls below the required level, the platform can automatically liquidate your long position.

With a short position, you expect the price to go down. If the price rises, your losses grow. If it rises far enough, your available margin can also become too low and your short position gets liquidated.

Simply put:

• Long liquidation: the price drops too far and the position is closed.
• Short liquidation: the price rises too far and the position is closed.

A lot of liquidations at once can strengthen a price move. When many long positions are liquidated, those positions have to be closed with sell orders. That can create extra selling pressure. When many short positions are liquidated, the opposite happens: the positions are closed with buy orders, which can create extra buying pressure.

Because of this, a drop can sometimes keep falling harder, or a rise can speed up even more. This kind of chain reaction is also called a liquidation cascade.

By the way, liquidation figures do not mean that exactly the same amount of crypto was bought or sold on the spot market. First and foremost, they are about closing derivatives positions.

Some trading platforms also offer hedge mode. That lets you hold a long and a short position at the same time. That does not mean liquidation risk disappears. Both positions can have different prices, margin rules, and liquidation levels, which means one of the positions can still get liquidated.

What Causes Crypto Liquidations?

In derivatives, crypto liquidations happen directly because of a price move that is big enough to push your available margin below the maintenance margin. For a long position, that is usually a drop. For a short position, that is usually a rise.

The biggest reason liquidation risk can rise quickly is often high leverage. With leverage, the same percentage price move has a much bigger impact on your relatively small margin deposit. The higher the leverage, the less room you usually have before your liquidation level is hit.

High volatility makes this even riskier. The crypto market can move fast, and the mark price can reach your liquidation threshold in a short time. With very high leverage, the price sometimes only has to move a little in the wrong direction.

The type of collateral also matters. If you use volatile crypto as collateral, its value can drop even while your position itself barely changes. Especially with cross margin or multiple types of collateral, that can put pressure on your available margin.

With DeFi loans, there are two common causes:

• The value of your collateral drops.
• The value of what you borrowed rises.

In both cases, the ratio between collateral and debt gets worse. If the health factor drops below the liquidation threshold, a liquidator can step in.

A stop-loss is also not automatic protection against every liquidation. Suppose your stop is triggered by the last traded price, while the platform checks liquidations based on the mark price. Then the mark price can hit your liquidation level before your stop-loss is activated. During fast moves, the final execution price can also differ from what you expected.

What Are the Effects of Liquidations on the Crypto Market?

Liquidations first and foremost mean the trader involved realizes a loss. Depending on the platform, liquidation or execution fees may also apply.

If many traders have similar high-leverage positions, a liquidation cascade can happen. That is a kind of domino effect. For example, an initial price drop hits the liquidation levels of long positions. Because of the forced closures, extra selling pressure appears in derivatives, which can push the price lower and put even more long positions at risk.

The same thing can happen with short positions, but upward. A price increase can force shorts to close through buys. That extra buying pressure can then strengthen the rise.

So liquidations are not always the original reason for a price move. Often it works the other way around: a drop or rise starts first, and then forced orders make the move bigger. That interaction is exactly what can cause sudden, choppy price action in the crypto market.

Open interest can also fall. Open interest is the total number of derivatives positions still open. When positions are liquidated, those contracts disappear from the market. This is also called rapid deleveraging: there is less leverage in the derivatives market.

You should read large liquidation amounts carefully. Such an amount does not automatically mean that exactly that much spot crypto was sold. The figures can include multiple platforms, contracts, and settlement methods. The direct process happens first in the derivatives or lending market.

Some platforms use an insurance fund, partial liquidations, or other risk mechanisms to absorb losses. But there is no universal protection. The exact rules and any remaining obligations depend on the platform and the situation.

How Can Traders Reduce Liquidation Risk?

You cannot fully eliminate the risk of a crypto liquidation, but you can reduce it. These are the main things to watch:

1. Use less leverage Lower effective leverage usually gives you more room between your entry price and your liquidation level. Small moves against your position then have less impact.

2. Limit the size of your position A smaller position limits how much of your account is exposed to one trade. However, the distance to your liquidation price also depends on your leverage, margin mode, and the platform’s rules.

3. Watch the mark price and maintenance margin Do not look only at the last traded price. For your liquidation risk, the mark price, available margin, equity, and maintenance margin ratio are especially important. These are the values the platform may use for risk control.

4. Use a stop-loss with enough room A stop-loss before your liquidation level can help you exit a trade earlier on your own. Just make sure you know which price triggers the stop and which price counts for liquidation. A stop-loss is not a guarantee during fast price moves.

5. Choose carefully between isolated and cross margin With isolated margin, the margin assigned to that position is basically separated from the rest of your available margin. With cross margin, available account margin is shared. That can keep a position alive longer, but it can also expose more of your balance and other positions to risk.

6. Do not add margin blindly Adding extra margin can move your liquidation level farther away from the current price. At the same time, you are putting more money into a position that is already losing. So topping up margin is not a complete plan, but a choice with extra risk.

Do you have a DeFi loan? Then you can lower liquidation risk by adding more collateral or repaying part of your debt. That raises your health factor and creates more room before a liquidator can step in.

Conclusion

Crypto liquidations are forced settlements that happen when a position or loan no longer has enough collateral. With futures and perpetuals, it is mainly about margin, leverage, maintenance margin, and the mark price. With DeFi loans, it is about the relationship between debt and collateral, often shown through the health factor.

High leverage and fast price moves make liquidations more likely. If many positions are hit at once, forced orders can make a drop or rise in the crypto market even stronger. That is why it is important to look not only at the price, but also at your margin, liquidation level, and the rules of the platform you use.