Currently, Compound (v2) handles liquidations by enabling anybody to liquidate an at-risk account by repaying some of the account's debt and receiving collateral in return worth 105% of the amount repaid. The fixed 5% "liquidation incentive" has a few weaknesses. Most of these arise from the liquidator's need to rebalance their portfolio by converting the seized asset gained back into the repaid asset lost. If the liquidator does not rebalance, they are now exposed to market movements in both assets and possibly run out of inventory to perform additional liquidations. Some weaknesses with this system:
(1) The incentive does not vary by asset. For very liquid collateral types (say ETH or DAI), the liquidator can easily convert the seized collateral back to the asset used to repay the borrower's debt, losing little to slippage. In this case, 5% may be too generous. For illiquid collateral types (say REP or WBTC), the liquidator may struggle to unload the collateral. In this case, 5% may be too little.
(2) The