Liquidation Penalty Fees

Liquidation penalty fees are additional costs imposed on a borrower when their position is forcibly liquidated by a protocol. These fees are designed to incentivize users to maintain their collateral ratios above the liquidation threshold and to reward the liquidators who perform the liquidation.

By making liquidation expensive for the borrower, the protocol encourages proactive risk management. The fee is typically a percentage of the collateral value that is either burned, sent to a protocol treasury, or paid directly to the liquidator as an incentive for their services.

This mechanism ensures that there is always an active market of liquidators ready to step in when a position becomes under-collateralized. Without these fees, liquidators might not have enough incentive to monitor and act on failing positions.

It is a core economic lever that balances the risks and rewards for all participants in a lending ecosystem. The penalty structure must be carefully calibrated to be high enough to encourage safety but not so high that it becomes predatory or discourages participation.