Liquidation penalties are fees charged to a borrower whose leveraged position is automatically closed by a protocol due to insufficient collateral. This cost is calculated as a percentage of the liquidated position value and deducted from the remaining collateral. The penalty covers the expenses associated with the liquidation process and often contributes to an insurance fund.
Incentive
The penalty serves as a powerful incentive to encourage users to manage their risk proactively and maintain adequate collateralization levels. By increasing the financial cost of allowing a position to be liquidated, the mechanism motivates borrowers to add collateral or close positions before reaching the trigger threshold. This behavioral dynamic reduces the frequency of liquidations and protects the protocol’s solvency.
Mechanism
The penalty mechanism is typically implemented via smart contracts that automatically assess the fee during the liquidation event. This automated process ensures consistency and efficiency, providing a reliable source of revenue for liquidators who execute the closure and for the insurance fund that absorbs potential shortfalls.
