In May 2022, UST collapsed and $40 billion evaporated. Simultaneously, ETH's price fell from $3,000 to $1,700 in the same month — a drop exceeding 43%. During this period, Aave and Sky's (formerly MakerDAO) crypto-backed stablecoin USDS (then called DAI) also faced massive liquidation pressure on ETH collateral. But USDS didn't collapse in the 2022 bear market, while UST did. The most fundamental difference between the two isn't 'which team was smarter' but the design of the underlying mechanisms: UST was algorithmic with no external asset backing; USDS was overcollateralized with 150%+ ETH buffer and automated liquidation as a final defense line.
The core logic of crypto-backed stablecoins is overcollateralization — you must deposit more collateral value than the stablecoins you borrow. Using Sky Protocol's USDS as an example: deposit $1,500 of ETH to mint at most $1,000 USDS (150% minimum collateral ratio). That $500 'buffer' protects against ETH price declines. The 'Liquidation Ratio' (minimum collateral ratio) is the liquidation trigger. For Sky Protocol's ETH-A lending vault, the liquidation ratio is 150%. If you deposited $1,500 ETH to mint $1,000 USDS, your collateral ratio is 150% — right at the boundary. If ETH drops 1%, your ETH becomes $1,485, dropping the collateral ratio to 148.5%, below the 150% trigger. At this point, your lending vault enters 'liquidatable status.' Liquidation process: the protocol takes your ETH collateral to 'auction,' using auction proceeds to repay the USDS you borrowed, returning any remainder to you. Key point: liquidation's purpose is ensuring every USDS in the protocol has sufficient collateral backing, keeping USDS's total collateral ratio consistently above 100% — preventing USDS from becoming bad debt.
Aave is one of DeFi's largest lending protocols, also using overcollateralized lending, but with different mechanism details from Sky Protocol. Aave uses a 'Health Factor' to measure lending vault safety: Health Factor = (collateral's liquidation threshold weighted value) / (total liability value). Health Factor > 1: vault is safe; Health Factor ≤ 1: vault can be liquidated. When a vault's health factor drops below 1, anyone can act as a 'Liquidator' to trigger liquidation — they repay part or all of the borrowing, receiving collateral plus a 'Liquidation Bonus' (typically 5–15%, depending on asset type). This reward mechanism creates a large number of liquidation bots (MEV Bots) monitoring all vault health factors around the clock. Once a vault approaches the liquidation threshold, bots race to become the liquidator and earn the reward. The logic of Aave's liquidation protecting protocol stability: liquidation immediately resolves the risk of 'vaults that have already fallen below safe thresholds' — repaying borrowings (USDC/USDT stablecoins) with real assets (ETH). Without liquidation mechanisms, bad debt accumulates in the protocol, potentially causing systemic paper losses across the entire lending pool, affecting all depositors.
After the May 2022 UST collapse, markets entered severe panic mode. ETH continued falling through the following two months, reaching approximately $880 in June 2022 (from $3,800 at year start — a decline exceeding 77%). This placed enormous pressure on USDS's (DAI's) collateral system: massive ETH collateral vaults triggered liquidations as ETH plummeted. The liquidation cascade unfolded: ETH falling from $3,000 to $2,000 → minimum collateral ratio vaults begin liquidating → liquidated ETH sold into secondary markets → more ETH selling further depresses ETH price → more vaults hit liquidation threshold → more ETH sold... This is the 'Liquidation Cascade.' Several key mechanisms prevented USDS from losing its peg during the cascade. Key protection 1: overcollateralization buffer. Because the liquidation ratio is 150%, ETH needs to fall over 33% (from a minimum-ratio vault's perspective) before collateral no longer covers borrowings. Key protection 2: tiered liquidation thresholds. Sky Protocol has multiple collateral types (ETH-A, ETH-B, ETH-C, stETH-B, etc.) each with different liquidation ratios (145%–170%) and debt ceilings. Tiered design distributes borrowers with different risk preferences across different vault types; liquidations occur in batches rather than all at once. Key protection 3: PSM as emergency peg channel. When market panic causes large-scale USDS selling → USDS begins deviating from $1 → arbitrageurs immediately swap 1 USDS for $1 USDC via PSM → this arbitrage pulls USDS back to $1, simultaneously destroying USDS supply on the market. PSM provides an immediate channel anchored to external fiat, preventing crypto-backed USDS from relying entirely on liquidation during stress periods.
Liquidation isn't infallible — in these situations it may fail or cause greater systemic damage. Situation 1: Flash Crash. If ETH crashes 50% within minutes, liquidation bots may not execute liquidations in time (blockchain block time limits), causing many vaults to fall below 100% collateral ratio before liquidation — protocol accumulates bad debt. On March 12, 2020 (DeFi's 'Black Thursday'), MakerDAO experienced many liquidations settling at $0 (lowest bidder had no competition due to competitors unable to get transactions on-chain in time due to network congestion) due to ETH flash crash + Ethereum network congestion, causing approximately $4 million in bad debt. Situation 2: Liquidation threshold set too low. If a DeFi protocol sets its liquidation ratio at 110%, the underlying asset only needs to fall 9% to trigger liquidation — but liquidation itself takes time to execute. If the asset continues falling 5% during execution, liquidation may not fully cover borrowings, creating bad debt. This is why Sky Protocol sets its primary ETH lending liquidation ratio at 145–170% rather than 110%. Situation 3: Insufficient collateral liquidity. Liquidation requires selling collateral on the market. If collateral is an illiquid token (small-cap altcoin), liquidation auctions may find no buyers, or massive liquidation selling directly collapses the collateral's market cap, making subsequent liquidations increasingly unable to cover borrowings. This is why mature lending protocols (Aave, Sky) only allow liquid assets (ETH, wBTC, stETH) as collateral.
Understanding liquidation mechanisms has two practical dimensions: as a borrower and as a depositor. As a borrower (collateral borrowing on Aave or Sky): understanding your own liquidation risk is the most important self-protection. Practical advice: don't control collateral ratio near the minimum liquidation threshold — on Aave, keep health factor above 1.5; on Sky, keep collateral ratio at 130–150%+ above the minimum (e.g., minimum 150%, maintain actual ratio at 200–225%); set price alerts to add collateral or repay when collateral price falls to within 80% of liquidation threshold; before major market volatility (major macro events), consider proactively reducing leverage. As a USDS or Aave stablecoin depositor: liquidation mechanism soundness directly affects your deposit safety. Aave's liquidation track record, Reserve Factor, and bad debt coverage fund (Safety Module) are key metrics for evaluating deposit safety. Sky Protocol's overall collateral ratio and DAI Reserve/PSM composition are also publicly available data worth periodically monitoring. Liquidation mechanisms aren't a 'guaranteed no problems' promise — they protect protocols from bad debt within normal market volatility ranges. Extreme market environments (2020 Black Thursday, 2022 LUNA collapse's chain liquidations) can still cause brief bad debt or peg pressure.