Liquidation Bonus

In a DeFi lending protocol, a liquidation bonus is a discount offered on the collateral seized from a borrower whose position has fallen below the required collateralization ratio. When a borrower's health factor drops below 1 (e.g., due to asset price volatility), their position becomes eligible for liquidation. To incentivize rapid action, the protocol allows liquidators to repay a portion of the borrower's outstanding debt in exchange for the borrower's collateral at a discounted price. This discount is the bonus, effectively providing the liquidator with an immediate, risk-adjusted profit on the transaction.

The mechanics are protocol-specific but follow a common pattern. For example, a protocol may set a liquidation penalty of 10% for the borrower. A portion of this penalty, say 5%, is then offered as the liquidation bonus to the liquidator. If a liquidator repays $100 of the borrower's debt, they would receive approximately $105 worth of the borrower's seized collateral. The remaining penalty may be retained by the protocol as a fee or insurance fund. This system creates a competitive marketplace for liquidation, ensuring the protocol's solvency is maintained with minimal delay.

The size of the bonus is a critical protocol parameter. A bonus that is too low may fail to attract liquidators during network congestion or high gas fees, leading to systemic risk from undercollateralized positions. Conversely, a bonus that is too high can be excessively punitive to borrowers and may encourage predatory behavior. Protocols often adjust these parameters through governance. The bonus is typically calculated and applied automatically via smart contracts upon the successful execution of a liquidate() function call, ensuring transparency and fairness in the process.

Key related concepts include the health factor (which triggers liquidation), the liquidation threshold (the collateral ratio at which liquidation occurs), and the close factor (the maximum percentage of a position that can be liquidated in a single transaction). Understanding the liquidation bonus is essential for both borrowers, to assess their risk exposure, and for participants looking to act as liquidators, as it defines the potential profitability of this specialized DeFi activity.

A liquidation bonus is a discount applied to the collateral seized from a borrower's underwater or undercollateralized position during a liquidation event. When a borrower's collateral value falls below the protocol's required health factor or collateralization ratio, the position becomes eligible for liquidation. To incentivize third-party participants, known as liquidators, to close this risky position promptly, the protocol allows them to purchase the distressed collateral at a price below its market value. This discount, typically ranging from 5% to 15%, constitutes the liquidator's profit when they immediately sell the seized assets on the open market.

The mechanism serves a critical function in maintaining protocol solvency. Without this incentive, liquidators might lack the economic motivation to act, allowing bad debt to accumulate and potentially destabilizing the entire lending pool. The bonus is effectively funded by the liquidation penalty paid by the defaulting borrower, which is added to their debt. For example, if a position with $100 worth of ETH collateral is liquidated with a 10% bonus, the liquidator can repay $90 of the borrower's debt to claim the full $100 in ETH. The process is typically executed via automated smart contracts or keeper networks that monitor positions in real-time.

Key parameters governing the bonus are set by protocol governance and include the liquidation threshold (the collateral value at which liquidation triggers) and the liquidation bonus percentage. These are carefully calibrated: a bonus that is too low may not attract liquidators during network congestion, while one that is too high excessively punishes borrowers and could lead to predatory behavior. The bonus often varies by asset, reflecting differences in volatility and liquidity; stablecoins might have a lower bonus than more volatile assets like cryptocurrencies.

In practice, a liquidation involves several steps. A liquidator calls the protocol's liquidate() function, repaying a portion or all of the borrower's outstanding debt using the protocol's base asset (e.g., DAI, USDC). In return, they receive an equivalent value of the borrower's collateral, plus the bonus. This is often facilitated by flash loans, allowing liquidators to execute the transaction without upfront capital. The immediate sale of the collateral on a decentralized exchange (DEX) like Uniswap completes the arbitrage, locking in the bonus as profit minus gas fees and slippage.

The concept is analogous to a "fire sale" discount in traditional finance but is fully automated and permissionless. It's a cornerstone of overcollateralized lending protocols such as Aave, Compound, and MakerDAO. Understanding the liquidation bonus is essential for both borrowers, who must manage their health factor to avoid it, and for aspiring liquidators, who operate bots and strategies to capture these opportunities in a competitive landscape.

In the context of lending and borrowing protocols like Aave or Compound, a liquidation bonus is a discount applied to the collateral seized from a borrower whose position has fallen below the required collateralization ratio. When a borrower's health factor drops below 1, their position becomes eligible for liquidation. A liquidator can repay a portion of the borrower's outstanding debt and, in return, receives the borrower's collateral at a value greater than the debt repaid. This bonus, typically expressed as a percentage (e.g., 5-15%), compensates the liquidator for the risk and gas costs of the transaction, ensuring the protocol's solvency by rapidly removing bad debt.

The design of the liquidation bonus is a critical incentive mechanism within a protocol's economic security model. It must be calibrated carefully: a bonus set too low may fail to attract liquidators, leading to a buildup of undercollateralized positions and systemic risk. Conversely, a bonus set too high can be overly punitive to borrowers and may encourage predatory behavior. The bonus is often implemented as a liquidation penalty from the borrower's perspective, representing the total loss they incur beyond the debt repayment. This mechanism aligns the economic interests of liquidators with the protocol's need for stability.

From a technical perspective, the bonus is enforced via smart contract logic in the liquidation process. For example, a liquidator might repay 100 DAI of a borrower's debt and receive $105 worth of the borrower's ETH collateral, netting a 5% bonus. This process is often facilitated by liquidation bots that monitor the blockchain for eligible positions. The existence of a reliable liquidation market with competitive bonuses is essential for maintaining the peg of stablecoins in algorithmic or collateralized systems, as it ensures that over-leveraged positions are cleared before they threaten the entire system's collateral backing.