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.
Glossar
Collateralized Debt Position
Mechanism ⎊ Collateralized Debt Positions represent a core component within decentralized finance, functioning as loans secured by cryptocurrency assets; these positions enable users to borrow assets against their crypto holdings, creating a dynamic interplay between lending and borrowing protocols.
Liquidation Penalty
Imposition ⎊ The penalty is a fee or discount applied to the proceeds of a forced sale of collateral during liquidation, designed to compensate the protocol or the liquidator for the operational cost and market disruption caused by the default.
Liquidation Penalty Mechanism
Trigger ⎊ Liquidation penalty mechanisms within cryptocurrency derivatives function as pre-defined contractual stipulations activated upon reaching a specified price threshold, initiating a cascade of financial consequences for the defaulting party.
Penalty
Consequence ⎊ A penalty within cryptocurrency, options trading, and financial derivatives typically represents a financial disincentive imposed for non-compliance with contract terms or exchange rules.