A liquidation fee is a penalty, often expressed as a percentage of the liquidated debt or collateral, charged to a borrower when their position in a decentralized finance (DeFi) lending protocol is liquidated. This occurs when the value of the borrower's posted collateral falls below a required threshold, known as the liquidation ratio or health factor, triggering an automated process to close the loan and protect the protocol from insolvency. The fee is a critical incentive mechanism, compensating liquidators—third parties who execute the liquidation—for their work and risk.
LABS
Glossary
Liquidation Fee
A penalty fee charged to a borrower when their collateral value falls below a required threshold, often shared between the liquidator and the lending protocol.
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definition
DEFI MECHANICS
What is a Liquidation Fee?
A liquidation fee is a penalty charged to a borrower when their collateralized loan position becomes undercollateralized and is forcibly closed by the protocol.
The fee structure serves multiple purposes within a protocol's economic design. Primarily, it ensures that liquidators are adequately compensated for the gas costs and execution risk involved in bidding on and settling undercollateralized positions. This competition among liquidators helps maintain market efficiency. Furthermore, the fee acts as a deterrent for borrowers, encouraging them to actively manage their positions by adding more collateral or repaying debt to avoid the financial penalty. Fees typically range from 5% to 15% but can vary significantly between protocols like Aave, Compound, and MakerDAO.
From an accounting perspective, the liquidation fee is usually deducted from the borrower's remaining collateral after the debt is repaid. For example, if a borrower has a $100 debt backed by $120 in ETH collateral and faces a 10% liquidation fee, a liquidator would repay the $100 debt to the protocol. In return, they would receive the $120 in collateral, netting a profit of $20 minus the $10 fee (10% of $100), which is often retained by the protocol's treasury or stability fund. The borrower loses their entire collateral position, minus any potential surplus if the collateral value significantly exceeded the debt plus fees.
The specific mechanics, including the liquidation threshold, fee percentage, and the existence of a liquidation bonus (a discount on the purchased collateral for the liquidator), are core protocol parameters governed by decentralized autonomous organization (DAO) votes. These parameters must be carefully calibrated: fees set too low may disincentivize liquidators during network congestion, risking protocol bad debt, while excessively high fees can unfairly penalize borrowers and reduce the appeal of the lending market.
how-it-works
DEFINITION
How a Liquidation Fee Works
A liquidation fee is a penalty charged to a borrower when their collateralized debt position is forcibly closed due to falling below a required health threshold. This fee compensates liquidators for the risk and effort of executing the transaction and helps protect the lending protocol's solvency.
A liquidation fee is a penalty, often expressed as a percentage of the debt or collateral value, automatically deducted when a liquidation event is triggered. This occurs when a borrower's collateralization ratio falls below the protocol's liquidation threshold, making their position undercollateralized and risky for the protocol. The fee is typically paid from the borrower's remaining collateral and serves two primary purposes: it incentivizes third-party liquidators to promptly close the risky position, and it creates a financial buffer for the protocol to cover bad debt if the liquidation process fails to recover the full loan amount.
The mechanics are protocol-specific. In systems like MakerDAO, the fee is known as a liquidation penalty and is added to the debt that must be covered by the collateral auction. In automated market maker (AMM)-based lending protocols like Aave or Compound, liquidators purchase the discounted collateral directly, with the fee effectively baked into the discount rate—for example, a 10% discount implies a fee for the borrower. The fee is a critical parameter in a protocol's risk management framework, balancing the need to incentivize liquidators against imposing excessive penalties on users.
For example, if a borrower's ETH-backed loan hits its liquidation point with $10,000 of debt, a 10% liquidation fee would increase the total to $11,000. A liquidator repays the $10,000 debt to the protocol and receives $11,000 worth of the borrower's collateral (ETH), netting a profit. The borrower loses their collateral, minus the fee. This process is essential for maintaining the overcollateralization of the entire system, ensuring lenders can be repaid even if asset prices plummet. The fee structure directly impacts protocol safety and borrower behavior.
key-features
MECHANISM BREAKDOWN
Key Features of Liquidation Fees
Liquidation fees are a critical economic mechanism in DeFi lending protocols, designed to compensate liquidators for their work and protect the protocol's solvency. Their structure directly impacts user risk, market efficiency, and system stability.
01
Incentive Mechanism
A liquidation fee (or liquidation penalty) is a premium paid by the borrower, added to the debt being repaid, to incentivize third-party liquidators. This creates a profitable opportunity for liquidators to repay the undercollateralized loan and seize the collateral, keeping the protocol solvent. Without this fee, there would be little economic reason for anyone to perform the liquidation.
02
Fee Structure & Calculation
Fees are typically a fixed percentage of the debt or collateral value being liquidated. Common structures include:
- Fixed Percentage: A set fee (e.g., 5-15%) applied to the liquidated amount.
- Dynamic Fees: Fees that can adjust based on market volatility or the size of the position.
- Liquidation Bonus: The fee is expressed as a discount on the collateral's market price, allowing the liquidator to buy it below market value. The fee is deducted from the borrower's remaining collateral after the debt is repaid.
03
Protocol Solvency Guardrail
The primary function of the fee is to ensure protocol solvency by making liquidation events economically attractive enough to happen swiftly. This prevents bad debt from accumulating on the protocol's balance sheet. The fee size is a trade-off: too low, and liquidations may not occur in time during high gas price environments; too high, and it excessively penalizes borrowers.
04
Impact on Borrower Health Factor
The fee is a direct cost to the borrower, worsening their financial position upon liquidation. It reduces the collateral remaining after the debt is cleared, causing a sharper drop in their Health Factor than the debt repayment alone. This makes it harder for a position to recover after a partial liquidation and increases the final loss for the borrower.
05
Liquidation vs. Stability Fee
It's crucial to distinguish a liquidation fee from a stability fee (or borrowing interest).
- Stability Fee: An ongoing interest rate accrued on the borrowed assets over time.
- Liquidation Fee: A one-time penalty triggered only if the borrower's collateral ratio falls below the required threshold. The liquidation fee is often significantly larger than accrued interest.
06
Example: Aave & Compound
Aave V3: Uses a configurable liquidation bonus (fee). For major assets like ETH, the liquidator receives a 5% bonus, meaning they repay $100 of debt to receive $105 worth of collateral. Compound V2: Employs a fixed liquidation incentive. For most markets, this is 8%, meaning the liquidator can seize up to 108% of the borrowed value in collateral, with the 8% being their fee. These real-world examples show how the fee is baked into the liquidation math.
MECHANISM OVERVIEW
Liquidation Fee Models: A Comparison
A comparison of the primary models used to calculate and distribute fees during the liquidation of a collateralized debt position.
| Feature | Fixed Fee | Dynamic Fee (Dutch Auction) | Hybrid Model |
|---|---|---|---|
Core Mechanism | A predetermined percentage of the collateral or debt is taken as a fee. | Fee starts high and decreases over time via an auction; final fee is the discount from the market price. | Combines a fixed base fee with a variable incentive component based on market conditions. |
Fee Determinants | Governance-set parameter. | Auction duration, starting discount, and market demand. | Base fee parameter and a variable function (e.g., based on volatility or system risk). |
Keeper Incentive | Predictable, but may be insufficient during high gas or volatile periods. | Directly aligns incentive with market conditions; high potential profit for fast execution. | Aims to provide a minimum guarantee while scaling rewards during stress. |
Protocol Revenue | Fixed and predictable. | Variable; can be zero if the auction clears at a small discount. | More stable base revenue with variable upside. |
Liquidation Cost to User | Known and capped in advance. | Uncertain; depends on auction outcome, potentially lower than fixed fee. | Partially known (base fee) with a variable, uncapped component. |
Complexity & Gas Cost | Low. Simple calculation. | High. Requires auction logic and longer execution time. | Medium. More complex calculation than fixed fee. |
Example Implementation | MakerDAO (historically), many early DeFi protocols. | Compound v2, Aave v2. | Aave v3 (with liquidation bonus), newer risk frameworks. |
Primary Risk Mitigated | Under-collateralization. | Under-collateralization and keeper coordination failure. | Under-collateralization while optimizing for cost and speed. |
examples
LIQUIDATION FEE
Protocol Examples & Fee Structures
A liquidation fee is a penalty paid by a borrower whose collateral is liquidated, designed to compensate the liquidator for their service and to protect the lending protocol's solvency. This section details how different DeFi protocols implement this critical mechanism.
06
Fee Structure Comparison
Protocols balance borrower disincentives and liquidator incentives differently:
- Protocol Revenue Model: Fees paid to the treasury (e.g., Maker's penalty).
- Liquidator Incentive Model: Discount/bonus on collateral (e.g., Aave, Compound).
- Hybrid/Operational Model: Covers gas costs (e.g., Liquity's reserve). Key variables include the liquidation threshold, health factor, and close factor, which together determine when and how the fee is triggered and distributed.
economic-incentives
ECONOMIC INCENTIVES & PROTOCOL DESIGN
Liquidation Fee
A liquidation fee is a penalty charged to a borrower when their collateralized debt position is automatically closed due to falling below a required health threshold, serving as a critical incentive mechanism in decentralized finance (DeFi) protocols.
A liquidation fee is a penalty imposed on a borrower when their collateralized debt position (CDP) is liquidated for falling below the protocol's required collateralization ratio. This fee, often expressed as a percentage of the debt or collateral value (e.g., 5-15%), is paid to the liquidator—the network participant who executes the liquidation—as a reward for providing this essential market service. The fee ensures there is always a financial incentive for liquidators to monitor and clear undercollateralized positions, thereby protecting the protocol's solvency and the funds of other users.
The fee structure is a core component of a protocol's economic security model. It must be carefully calibrated: a fee set too low may not attract enough liquidators during market volatility, increasing systemic risk, while a fee set too high can excessively punish borrowers and deter protocol usage. Protocols like MakerDAO and Aave implement dynamic fee models where the fee can vary based on market conditions or the type of collateral asset. A portion of the fee may also be retained by the protocol's treasury or stability fund as an additional revenue stream and risk buffer.
From a borrower's perspective, the liquidation fee represents a significant loss beyond the initial collateral, making effective position management and understanding of liquidation thresholds paramount. For liquidators, the fee creates a competitive marketplace; they often use sophisticated bots to identify and bid on profitable liquidation opportunities, a process known as MEV (Maximal Extractable Value). This dynamic interplay between borrower risk, liquidator incentive, and protocol parameters is fundamental to maintaining stability in overcollateralized lending systems without relying on centralized intermediaries.
security-considerations
LIQUIDATION FEE
Security & Risk Considerations
A liquidation fee is a penalty charged to a borrower when their collateralized debt position (CDP) is liquidated for falling below the required health threshold. This fee compensates liquidators for their work and acts as a disincentive for risky borrowing.
01
Core Mechanism & Purpose
The liquidation fee is a percentage-based penalty deducted from the borrower's remaining collateral or added to their debt during a liquidation event. Its primary purposes are:
- Compensating Liquidators: Covers gas costs and provides a profit incentive for liquidators to close unhealthy positions.
- Risk Deterrence: Acts as a financial penalty to discourage borrowers from operating positions too close to the liquidation threshold.
- Protocol Safety: Helps protect the lending protocol from undercollateralized debt by ensuring liquidators are adequately rewarded to act swiftly.
02
Fee Structure & Calculation
Liquidation fees are not uniform and vary significantly by protocol and asset. Key structural elements include:
- Fixed vs. Variable Rates: Some protocols use a fixed percentage (e.g., 5-15%), while others have dynamic fees based on market volatility.
- Collateral Deduction: The fee is typically taken from the seized collateral before it's sold, reducing the borrower's recovery.
- Debt Addition: In some systems, the fee is added to the borrower's debt obligation, increasing what they must repay to reclaim remaining collateral.
- Example: A 10% fee on $10,000 of seized ETH would result in a $1,000 penalty for the borrower.
03
Borrower Risk: The 'Liquidation Penalty'
For borrowers, the liquidation fee represents a direct and often substantial financial loss. Key risks include:
- Amplified Losses: The fee is applied on top of the market losses that triggered the liquidation, leading to a larger effective loss than the price drop alone.
- Recovery Impact: A high fee can significantly erode or eliminate any collateral remaining after the debt is repaid, making it harder to recover the position.
- Protocol Comparison: Borrowers must factor in the liquidation penalty (fee) alongside the liquidation threshold and health factor when assessing risk across different platforms.
04
Liquidator Incentives & Arbitrage
The fee creates a competitive market for liquidators. Their profit is the difference between the discounted collateral they purchase and its market value, minus costs.
- Profit Calculation:
Profit = (Collateral Value * Discount) - (Gas Costs + Effort). - Arbitrage Bots: Sophisticated MEV (Miner/Maximal Extractable Value) bots often dominate this space, competing to be the first to execute profitable liquidations.
- System Health: Proper fee calibration is critical. Fees too low may disincentivize liquidators, risking protocol insolvency. Fees too high can be excessively punitive to borrowers.
05
Protocol Design & Parameter Governance
Setting the liquidation fee is a critical governance decision that balances system safety with user experience.
- Risk Parameters: The fee is part of a suite of parameters including Loan-to-Value (LTV) ratio, liquidation threshold, and liquidation bonus.
- Governance Control: In decentralized protocols like Aave or Compound, fee levels are typically set and adjusted via governance token votes.
- Asset-Specific Fees: Riskier or more volatile collateral assets often have higher liquidation fees to account for increased market risk during the liquidation process.
06
Related Concepts & Comparisons
Understanding liquidation fees requires context from related mechanisms:
- Liquidation Bonus (Discount): The incentive for liquidators, often conflated with the fee. The borrower pays a fee; the liquidator receives a bonus on the collateral price.
- Health Factor / Collateral Ratio: The metric that triggers liquidation when it falls below 1.0 or a set threshold.
- Margin Call: A traditional finance equivalent, but in DeFi, the process is fully automated and enforced by smart contracts.
- Safety Module: Some protocols use fees to fund an insurance or treasury backstop for bad debt.
LIQUIDATION FEE
Frequently Asked Questions (FAQ)
Common questions about the fees incurred during the forced closure of undercollateralized positions in DeFi lending and borrowing protocols.
A liquidation fee is a penalty charged to a borrower when their collateralized debt position (CDP) is liquidated for falling below the required collateralization ratio. This fee is paid from the liquidated collateral and is distributed to the protocol's treasury and/or the liquidator who executed the forced closure. It serves as a financial disincentive for borrowers to become undercollateralized and compensates the network for the risk and work involved in the liquidation process. For example, on Aave, the liquidation penalty is a fixed percentage (e.g., 5% for ETH) added to the debt that must be repaid.
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