Liquidation Premium

A Liquidation Premium is the discount at which a liquidator can purchase the collateral of a defaulting position, or the fee paid to the entity that executes the liquidation. This premium serves as an incentive for third-party participants to monitor the market and act immediately when a position crosses its liquidation threshold, ensuring that the protocol remains solvent.

By offering a profit opportunity to the liquidator, the protocol ensures that there is always someone willing to clear the bad debt. However, this premium is a direct cost to the user who is being liquidated, adding to the total financial impact of the event.

The size of the premium is often calibrated based on the liquidity and volatility of the underlying asset to ensure it is attractive enough to entice liquidators while remaining fair to the user.