In its latest upgrade, Silo, a decentralized lending protocol known for its isolated money markets, is offering a new way to liquidate undercollateralized loans in a bid to better protect lenders.

Silo V3, unveiled Tuesday, adds a protocol-level insolvency protection mechanism to reduce the dependency on DEX liquidity.

Namely, Silo v3 will offer a way to repay lenders by absorbing pledged collateral into the loan asset at a discount — "fully covering lenders even when external liquidity is insufficient, fragmented, or delayed."

Traditional DeFi lending protocols assume that whenever a borrower’s position becomes undercollateralized, the collateral can be sold on a decentralized exchange to repay lenders. However, the Silo team argues, this assumption often fails during market stress when liquidity is fragmented, thin, or temporarily unavailable.

“We’ve redesigned the lending model so solvency no longer hinges on perfect market liquidity, and lenders are compensated explicitly through liquidation discounts and fees,” Silo wrote. “This shifts the risk balance in favor of lenders while unlocking access to entirely new categories of collateral.”

Silo V3 features two liquidation routes, only activating the new protective measure when DEX liquidity is thin. If a loan is above the “DEX Liquidation Threshold,” the position will be liquidated through traditional DEX redemption mechanisms, while if it is above the Collateral-Debt Swap Threshold, “the protocol activates an alternative path.”

Valuable collateral

While this mechanism may seem like a way to support “low-quality assets,” or a potentially riskier prospect for lenders willing to accept thinly traded tokens as collateral, the team notes “asset quality remains determined by market participation rather than protocol enforcement.”

“Thousands of assets have real fundamental value, but without deep, instant onchain liquidity, they’ve been excluded from credit markets or introduced hidden risks for lenders,” Silo said in the announcement.

For instance, structured LP tokens, liquid staking and restaking representations, time-locked tokenized strategies, and “CEDEFI assets with off-chain redemption paths” could be valuable forms of collateral that are currently locked out of onchain lending setups because they “may not be continuously accessible through liquidity on decentralized exchanges.”

“We believe Silo v3 represents a structural evolution in onchain credit — expanding what assets can access lending markets while making those markets safer by design,” Silo added.