Liquidation Rebates

Liquidation rebates are financial incentives provided to liquidators who identify and close undercollateralized positions within a lending protocol or derivative exchange. When a user's collateral falls below a specific threshold, the protocol allows liquidators to purchase the collateral at a discount or receive a portion of the penalty fee paid by the defaulting user.

This rebate compensates the liquidator for the technical costs and market risks associated with executing the transaction on-chain. By making the act of liquidation profitable, the protocol ensures that there is always an active group of participants monitoring for insolvency.

This mechanism is fundamental to maintaining the solvency of lending markets and ensuring that debt remains fully backed by collateral. It reduces the time that a protocol spends in a state of undercollateralization, which is crucial for maintaining trust and system stability.

Effective rebate structures are calibrated to be high enough to attract participants but not so high that they incentivize predatory behavior.