Liquidation Bonus

A liquidation bonus is a financial incentive, typically expressed as a percentage discount, offered to participants (liquidators) who repay the debt of an undercollateralized loan in a decentralized lending protocol. When a borrower's collateral value falls below the required collateralization ratio, their position becomes eligible for liquidation. To ensure the protocol remains solvent, liquidators can repay the borrower's outstanding debt in exchange for the collateral at a price below its market value, profiting from the difference. This discount is the liquidation bonus, and it is a critical component for maintaining system health by making liquidation a profitable activity.

The mechanics are protocol-specific but generally follow a standard process. A liquidator calls a smart contract function to repay the borrower's debt, often in the protocol's stablecoin. In return, the liquidator receives the borrower's collateral—such as ETH or WBTC—valued at a discount determined by the liquidation penalty or bonus parameter. For example, with a 5% bonus, a liquidator repaying $10,000 of debt would receive approximately $10,500 worth of collateral. This creates a competitive liquidator market that helps close risky positions quickly before the protocol accrues bad debt, protecting all depositors.

Key parameters governing this process include the liquidation threshold (the collateral value at which liquidation triggers) and the liquidation bonus size. Protocols like Aave and Compound carefully calibrate these values. A bonus that is too low may not attract enough liquidators during market volatility, risking protocol insolvency. Conversely, a bonus that is too high can excessively punish borrowers and increase system volatility. The bonus is often funded directly from the borrower's remaining collateral, meaning it represents an additional loss on top of the debt repayment for the liquidated user.

The liquidation bonus is distinct from a liquidation fee, though the terms are sometimes used interchangeably. Technically, the 'bonus' is the liquidator's reward, while a 'fee' might refer to a separate penalty paid by the borrower that is split between the protocol treasury and the liquidator. Understanding this mechanism is essential for both borrowers managing their health factor and for liquidators running automated bots. It exemplifies the incentive-driven design of DeFi, where economic rewards are used to align participant behavior with the protocol's need for stability and security.

A liquidation bonus is a discount offered on the collateral seized from a borrower whose loan has fallen below the required collateralization ratio. When a borrower's health factor drops below a protocol's threshold (e.g., 1.0 on Aave or Compound), their position becomes eligible for liquidation. To incentivize a liquidator—an external actor or bot—to repay the borrower's outstanding debt, the protocol allows them to purchase the borrower's collateral at a price below the market rate. This discount, typically ranging from 5% to 15%, constitutes the liquidator's profit when they later sell the seized assets on the open market.

The mechanics are executed atomically in a single blockchain transaction. The liquidator calls the protocol's liquidate() function, providing the necessary capital to cover the borrower's debt plus a potential penalty fee. In return, the protocol transfers the equivalent value of the borrower's collateral, plus the bonus percentage, to the liquidator. For example, if a borrower has $100 worth of ETH as collateral with a 10% bonus, a liquidator repaying $80 of debt would receive $88 worth of ETH. This system ensures liquidation efficiency and protects the protocol's solvency by rapidly removing bad debt from the system.

The bonus serves a critical role in maintaining protocol safety. By creating a competitive market for liquidations, it ensures that undercollateralized positions are resolved quickly before their deficit worsens, which protects other depositors from incurring losses. The size of the bonus is a key protocol parameter: set too low, and liquidations may not occur swiftly enough during high volatility; set too high, and it can excessively penalize borrowers. This mechanism is foundational to overcollateralized lending platforms like MakerDAO, Aave, and Compound, where it acts as a market-driven enforcement tool for financial discipline.

A liquidation bonus is a discount offered on the collateral seized from a borrower when their position is liquidated. In a typical lending protocol like Aave or Compound, if a borrower's collateral value falls below a required health factor or collateral factor, their position becomes eligible for liquidation. To incentivize third-party participants (liquidators) to repay the borrower's outstanding debt, the protocol allows them to purchase the seized collateral at a price below the market rate. This discount is the liquidation bonus, and it serves as the liquidator's profit for performing this critical system maintenance function.

The design of the bonus is a core economic parameter that balances protocol safety with market efficiency. A bonus that is too low may fail to attract liquidators during periods of high network congestion or market volatility, increasing protocol insolvency risk. Conversely, a bonus that is too high can be excessively punitive to borrowers and may encourage predatory behavior. The bonus is often expressed as a percentage, such as a 5-10% discount on the collateral's value. This mechanism ensures that liquidators are compensated for their gas costs, execution risk, and the capital they must temporarily lock up to execute the liquidation transaction.

From a systemic perspective, the liquidation bonus is a key component of incentive alignment. It transforms the necessary act of risk management into a profitable opportunity, creating a decentralized network of actors who actively police the protocol's solvency. This design eliminates the need for a centralized authority to manage bad debt. The bonus, combined with the liquidation threshold and liquidation penalty (often used synonymously with the bonus), forms a tripartite mechanism that defines the economics of default within DeFi's overcollateralized lending models, ensuring lenders are made whole while efficiently clearing unhealthy positions from the system.