Understanding MakerDAO's Liquidation System and Its Upgrade Plan

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MakerDAO stands as one of the most influential decentralized finance (DeFi) protocols, pioneering the concept of over-collateralized stablecoins through its DAI token. At the heart of this ecosystem lies a sophisticated liquidation system designed to maintain solvency and price stability. As DeFi evolves, so too must its foundational mechanisms. This article explores the architecture of MakerDAO’s current liquidation framework, analyzes past failures, and details the upcoming Liquidation 2.0 upgrade—a pivotal evolution aimed at enhancing efficiency, accessibility, and resilience.

The Core Functions of MakerDAO's Liquidation System

MakerDAO enables users to lock up digital assets as collateral in exchange for minting DAI, a USD-pegged stablecoin. To ensure system integrity during market volatility, the protocol employs a robust liquidation mechanism with two primary objectives:

  1. Risk Mitigation: Automatically trigger forced closures when collateral ratios fall below predefined thresholds, preventing undercollateralized debt.
  2. Price Stability: Manage DAI’s supply dynamics to minimize deviation from its $1 peg by influencing market incentives.

These functions are executed through a series of smart contract-driven auctions that engage third-party participants known as Keepers—automated bots or individuals who monitor and act on liquidation opportunities.

👉 Discover how decentralized finance protocols maintain stability during market shocks.

How DAI Maintains Price Stability

Since January 2024, DAI’s market capitalization has surged from under $1 billion to over $5.2 billion—a testament to growing trust in its stability mechanism. The protocol leverages two key tools to manage supply and demand imbalances:

During periods of high demand, such as the DeFi boom, DAI often traded at a premium. To expand issuance capacity, MakerDAO introduced USDC as a collateral asset, backed by off-chain reserves. Through the PSM (Pauseable Stability Module), users can swap DAI and USDC with minimal slippage—effectively anchoring DAI’s value via arbitrage between Coinbase’s 1:1 USDC-to-USD conversion and PSM.

This integration means traders can profit from any DAI price deviation, reinforcing its peg through decentralized market forces rather than centralized intervention.

The Three Auction Mechanisms in Liquidation 1.0

The original liquidation system relies on three distinct English-style auctions, each serving a unique role in maintaining system health.

Surplus Auction

When net surplus (excess revenue after covering costs) exceeds a governance-set threshold (e.g., 500K DAI), the system initiates a surplus auction. A fixed amount of DAI (e.g., 50,000) is auctioned off to bidders offering MKR tokens—the lowest MKR bid wins. Winning bids result in MKR being burned, reducing total supply and potentially increasing its value.

This mechanism rewards MKR holders while tightening monetary policy during surplus periods.

Collateral Auction

If a user’s collateral ratio drops below the liquidation threshold, their position becomes eligible for collateral auction. In this English auction format, Keepers bid increasing amounts of DAI for decreasing portions of the collateral. The highest bidder secures the asset.

However, if remaining collateral cannot cover the debt plus penalty, a reverse auction begins: participants compete to accept the least amount of collateral for a fixed DAI obligation.

Debt Auction

In extreme scenarios—such as rapid price declines leading to undercollateralization—the system may incur debt. After using buffer funds, if liabilities persist beyond a set threshold, a debt auction is triggered. Participants bid DAI for newly minted MKR tokens. The lowest DAI-per-MKR bid wins, injecting liquidity into the system while diluting MKR supply.

Lessons from the March 2020 “Black Thursday” Crash

On March 12, 2020—commonly referred to as “312”—a sharp market downturn exposed critical flaws in Liquidation 1.0:

  1. Network Congestion: Rapid price drops triggered thousands of simultaneous liquidations. Ethereum gas prices spiked, delaying transactions. Many auctions failed to settle, resulting in zero-bid liquidations where collateral was sold for nothing.
  2. Keeper Incentive Misalignment: High gas costs and uncertain price recovery reduced Keeper participation. With no immediate profit potential, many opted out.
  3. DAI Liquidity Crunch: As panic buying drove demand for stablecoins, DAI’s price soared above $1. Limited circulating supply made it costly for Keepers to acquire DAI for bidding.

In response, MakerDAO slashed borrowing rates, reduced savings yields to zero, and fast-tracked USDC integration via PSM. Eventually, a debt auction raised sufficient DAI to restore solvency.

This event underscored the need for a more responsive, scalable liquidation architecture.

👉 Learn how modern DeFi systems prevent cascading liquidations during market stress.

Introducing Liquidation 2.0: A Paradigm Shift

To address these vulnerabilities, MakerDAO proposed Liquidation 2.0 in February 2025, with an executive vote launched in April. This upgrade focuses on three core improvements:

Transition to Dutch Auctions

Unlike English auctions that start low and rise, Dutch auctions begin high and decline over time. The system sets an initial price that decreases according to a predefined function. Keepers can claim collateral instantly at any point before the price resets—eliminating multi-round bidding delays and reducing front-running risks.

This shift dramatically improves execution speed and reduces reliance on prolonged transaction competition.

Removal of Keeper Entry Barriers

Previously, collateral was auctioned in fixed batches, requiring substantial upfront capital. Now, any quantity of collateral can be purchased, allowing smaller players to participate without full-position funding.

This democratizes access and increases market depth during high-pressure events.

Native Flash Loan Support

One of the most transformative changes: Keepers can now use flash loans within a single transaction. This means they can borrow DAI temporarily, buy discounted collateral, sell it on decentralized exchanges (DEXs), repay the loan, and pocket profits—all atomically.

This slashes liquidity requirements and enables participation from entities without large idle capital reserves.

Smarter Incentive Design

Rather than rewarding early bidders indiscriminately, Liquidation 2.0 introduces risk-adjusted incentives:

Additionally, future integrations may link external liquidity sources like DEX aggregators to further enhance auction competitiveness.

Why This Upgrade Matters for DeFi

Compared to simpler models used by platforms like Aave or Compound—where liquidators repay debt directly in exchange for collateral discounts—MakerDAO’s approach is inherently more complex due to slower oracle updates (minimum 1-hour delay). However, this complexity allows finer control over systemic risk.

The 2025 market correction ("519") demonstrated improved resilience: DAI remained tightly pegged despite volatility, thanks in part to diversified collateral—including stablecoin-backed assets like USDC.

Liquidation 2.0 represents not just a technical upgrade but a philosophical shift: from isolated auction mechanics to an integrated DeFi liquidity layer that leverages flash loans, real-time pricing, and adaptive incentives.

Frequently Asked Questions (FAQ)

Q: What is a Keeper in MakerDAO?
A: A Keeper is an automated bot or user that monitors vaults for undercollateralization and triggers liquidations to maintain system stability.

Q: Why did MakerDAO switch from English to Dutch auctions?
A: Dutch auctions are faster and more efficient during high-congestion events, allowing instant settlement without multi-round bidding wars.

Q: How do flash loans improve liquidation efficiency?
A: They allow Keepers to perform capital-intensive operations without holding large reserves—reducing barriers and increasing participation.

Q: Can anyone become a Keeper?
A: Yes—anyone with technical capability or access to automation tools can run a Keeper node and participate in auctions.

Q: What role does USDC play in DAI stability?
A: USDC provides off-chain-backed collateral and enables low-slippage swaps via PSM, acting as a critical buffer during liquidity crunches.

Q: How does Liquidation 2.0 prevent another “Black Thursday”?
A: By improving speed (Dutch auctions), lowering capital barriers (flash loans), and aligning incentives with systemic risk reduction.

👉 Explore next-generation DeFi risk management tools shaping the future of decentralized finance.

Core Keywords

By reimagining how liquidations interact with broader DeFi infrastructure, MakerDAO is building a more resilient foundation for decentralized credit—one that adapts not just to today’s markets, but tomorrow’s challenges.