Liquidation Bonus

A liquidation bonus is a discount offered on the collateral seized from an undercollateralized loan position, paid to the party (the liquidator) who successfully executes the liquidation. When a borrower's collateral value falls below the required collateralization ratio, their position becomes eligible for liquidation to protect the protocol from bad debt. To ensure this critical risk-management function is performed swiftly, protocols offer liquidators the chance to purchase the distressed collateral at a price below its market value, with the discount constituting their profit. This mechanism is also referred to as a liquidation discount or liquidation incentive.

The process is triggered automatically by smart contracts. For example, if a user borrows $10,000 worth of stablecoins against $15,000 in ETH collateral (a 150% ratio) and the protocol's liquidation threshold is 110%, their position becomes liquidatable if the ETH value drops to $11,000. A liquidator can then repay part or all of the $10,000 debt and, in return, receive a corresponding portion of the ETH collateral at a discounted rate, such as 5% off the market price. This immediate arbitrage opportunity ensures liquidations are executed in a decentralized, permissionless manner without relying on a centralized authority.

The size of the bonus is a critical protocol parameter. A liquidation bonus that is too low may not attract enough liquidators during high network congestion, leading to delayed liquidations and increased systemic risk. Conversely, a bonus that is too high can be excessively punitive to borrowers, as it allows liquidators to claim a larger share of their remaining collateral. Protocols like Aave and Compound carefully calibrate this value, often setting it between 5% and 10%, to balance market efficiency with user protection. The bonus is typically denominated in the collateral asset being seized.

This incentive structure is fundamental to the stability of overcollateralized lending protocols. By creating a profitable, competitive market for liquidation services, it helps ensure that bad debt is minimized and that the protocol's solvency is maintained even during periods of high volatility. The liquidator's profit comes directly from the discounted collateral, not from the protocol's treasury, making the system self-sustaining. Understanding the liquidation bonus is key for both borrowers managing their risk and for participants looking to engage in liquidation farming as a strategy.

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 position becomes eligible for liquidation, a liquidator can repay a portion of the borrower's outstanding debt in exchange for the borrower's collateral at a reduced price. This discount, typically expressed as a percentage (e.g., 5-10%), constitutes the liquidator's profit. The mechanism ensures that liquidators are compensated for their capital and effort, which is critical for maintaining the protocol's solvency by swiftly resolving unhealthy positions before they threaten the system.

The process is triggered automatically by smart contracts when a user's health factor drops below 1.0. A liquidator calls the protocol's liquidation function, paying off the borrower's debt—often in a stablecoin like DAI or USDC—and receives the equivalent value of the borrower's collateral (e.g., ETH or WBTC) plus the bonus. For example, repaying $100 of debt might grant the liquidator $105 worth of ETH, netting a $5 bonus. This creates a competitive marketplace where liquidators use bots to monitor the blockchain for these opportunities, ensuring rapid execution.

The bonus percentage is a crucial protocol parameter set by governance. It must be high enough to incentivize liquidators but low enough to minimize the loss incurred by the borrower, whose remaining collateral is reduced by the bonus amount. This design directly impacts user experience and risk. Protocols like Aave and Compound use this model, with bonuses varying by asset based on volatility and liquidity. The system's efficiency relies on this economic incentive to protect the protocol from bad debt and maintain overall stability in the lending pool.

A liquidation bonus is a financial incentive, typically a percentage discount on the collateral's market value, offered to third-party liquidators for promptly repaying a borrower's undercollateralized debt position. This mechanism is a critical component of overcollateralized lending protocols like Aave and Compound, designed to protect the system from bad debt by ensuring that loans remain sufficiently backed by collateral. The bonus compensates liquidators for the capital, effort, and slippage risk involved in the transaction, creating a competitive market for maintaining protocol solvency.

The process is triggered when a user's health factor or collateral ratio falls below a predefined safe threshold, often due to a drop in collateral value or a rise in borrowed asset value. Upon liquidation, the liquidator repays part or all of the outstanding debt on behalf of the borrower. In return, they can seize a corresponding amount of the borrower's collateral at a price below the current market rate—this discount is the liquidation bonus. For example, with a 5% bonus, a liquidator repaying $100 of debt receives $105 worth of collateral, profiting from the difference.

The bonus rate is a key system parameter that protocol governance must carefully calibrate. If set too low, it may fail to incentivize sufficient liquidator activity, allowing undercollateralized positions to persist and increasing systemic risk. If set too high, it can lead to excessively punitive liquidations for borrowers and potential market instability from aggressive liquidation cascades. Protocols often implement liquidation caps and gradual bonuses to mitigate these extremes.

Beyond simple discounts, advanced mechanisms exist. Some protocols use auction-based liquidations, where collateral is sold via a batch or Dutch auction, with the bonus effectively being the difference between the final auction price and the debt value. Others employ liquidation thresholds and close factor limits to control the size and impact of each liquidation event. These designs aim to balance efficiency, fairness, and market stability.

The economic role of the liquidation bonus extends beyond individual transactions. It is a foundational incentive alignment tool that externalizes the cost of risk management to a decentralized network of profit-seeking actors. This creates a robust, automated defense against insolvency without requiring a centralized authority, making the protocol more resilient and trust-minimized. The continuous competition among liquidators helps ensure that collateral is priced efficiently during stress events.