What Is the Role of the ‘Liquidation Penalty’ in Maintaining the Health of a Collateralized Debt Position (CDP)?

The Liquidation Penalty is a fee charged to the borrower whose CDP is liquidated and is paid to the liquidator. It acts as an incentive for liquidators to step in quickly, ensuring that the bad debt is covered and the protocol remains solvent.

The penalty must be large enough to compensate the liquidator for their risk and gas fees, but not so large that it punishes the borrower excessively.