How Does the Liquidation Penalty Mechanism Function in an Over-Collateralized System?

The liquidation penalty is a fee imposed on a borrower whose Collateralized Debt Position (CDP) is liquidated because the collateral value has dropped below the minimum required ratio. The penalty is typically a percentage of the collateral, which is then added to the debt to incentivize the borrower to manage their position responsibly.

This penalty is often used to cover the costs of the liquidation process and, in some systems, to contribute to the protocol's stability fund, thereby protecting the stablecoin's peg.