DeFi Liquidation Models: Bonus vs Penalty
The DeFi landscape is characterized by two distinct approaches to liquidating risky loans: the bonus model and the penalty model. In the former, liquidators receive extra collateral as a reward for repaying debt, effectively making borrowers pay through additional collateral lost. Conversely, in the penalty model, a borrower is charged an additional fee when their position is liquidated, with the protocol retaining this fee.
The choice between these models has significant implications for incentives, keeper participation, and protocol solvency. Bigger bonuses can accelerate liquidations but lead to more value leakage from borrowers, while larger penalties strengthen protocol buffers but must still attract auction buyers.
Money-market pools such as Compound and Aave employ the bonus model, where liquidators receive a protocol-set discount or multiplier on seized collateral. This approach relies on liquidators and MEV searchers competing to execute liquidations at a profit, with larger bonuses potentially encouraging unnecessary liquidations around risk thresholds.