Liquidation Penalty

A liquidation penalty is the extra amount a borrower loses beyond the debt when their position is closed by force. It exists to pay whoever performs the liquidation: closing an undercollateralised position costs gas and carries price risk, and nobody would do it for nothing, so the protocol offers the collateral at a discount and the borrower funds that discount. The size varies by protocol and by collateral type, with more volatile collateral generally carrying a larger penalty because the position is riskier to close. Two practical points follow. A liquidation is not simply an exit at the market price — it is an exit at a worse one, which is why the difference between managing a position and being liquidated out of it is larger than the price move that triggered it. And a protocol that sets the penalty too low may find positions left unliquidated, which is how bad debt begins.