DeFi protocols have two very different ways of paying for the messy business of liquidating under-collateralized loans. In money-market pools like Compound and Aave, liquidators get a bonus in extra collateral. In MakerDAO's vault system, the borrower pays a penalty that goes to the protocol. Each design shifts the cost and the risk in a different direction.
How Money-Market Pools Pay Liquidators
Compound and Aave operate on a bonus model. When a position slips below the required collateral level, a liquidator steps in, repays some of the debt, and seizes collateral worth more than what they put in. The extra amount is the liquidation bonus, set by the protocol.
Compound exposes a parameter called liquidationIncentive. A value of 1.08, for example, means an 8 percent bonus: the liquidator can walk away with collateral worth 8 percent more than the debt they covered. Aave defines a Health Factor that triggers liquidation, plus a liquidationBonus that specifies the discount or bonus transferred to liquidators when they purchase collateral.
In this model, the protocol doesn't levy a separate fee on the borrower. The cost is implicit. The borrower effectively pays the liquidator through the extra collateral that gets seized. No penalty is collected by the protocol itself.
MakerDAO's Penalty-First Approach
MakerDAO's vault system works differently. When a vault is liquidated, a penalty is added to the vault's debt. Auctions then seek to recover the original debt plus that penalty. The penalty is revenue to the protocol, not a direct bonus paid to liquidators.
That's a key difference. In the money-market model, the extra value goes straight to the person who performs the liquidation. In Maker's model, auction participants still aim to buy collateral at a discount to market, but the protocol keeps the penalty as a buffer against losses.
Maker's Liquidations 2.0 introduced Dutch auctions to make the process more efficient. But audits have flagged the system as complex and parameter sensitive, meaning small changes in settings can have outsized effects on how auctions clear.
The Calibration Problem
Neither model is free. Bigger bonuses speed up liquidations by giving liquidators more room to cover slippage and gas costs. But they also leak more value out of the borrower's position. A large bonus can even encourage unnecessary liquidations near the threshold window, as liquidators race to grab the reward.
Penalties work in the opposite direction. A larger penalty strengthens the protocol's loss-absorbing capacity and can offset auction costs. But it must be calibrated so that auctions still clear efficiently. If the penalty makes the debt too high relative to the collateral, buyers may not show up.
Both systems ultimately force a trade-off between speed and fairness. The bonus model prioritizes quick, reliable liquidations at the borrower's expense. The penalty model builds a safety net for the protocol, but only if the auction market stays liquid enough to absorb the risk.
