Bad Debt

In the context of decentralized finance (DeFi) and blockchain lending protocols, bad debt occurs when a borrower's collateralized loan position becomes underwater—meaning the value of the posted collateral falls below the value of the borrowed assets—and the protocol's automated liquidation mechanism fails to close the position in time. This failure leaves the protocol with an outstanding loan that is not fully backed by assets, creating a loss that is typically socialized among all liquidity providers or covered by a protocol-owned insurance fund. The primary causes are extreme market volatility, liquidation cascades, and network congestion preventing timely execution of liquidations.

The mechanics are protocol-specific but follow a general pattern. A user opens a collateralized debt position (CDP) on a platform like Aave or Compound, locking crypto assets to borrow other assets. The protocol sets a liquidation threshold (e.g., 80% loan-to-value). If the collateral value drops, pushing the health factor or collateral ratio below this threshold, the position becomes eligible for liquidation. Liquidators are incentivized to repay part of the debt in exchange for the collateral at a discount. Bad debt accrues when no liquidator steps in, often because the liquidation incentive is insufficient or transaction costs are too high during market crashes.

Notable historical examples underscore its systemic risk. The 2022 collapse of the Terra/LUNA ecosystem caused massive bad debt across DeFi as LUNA collateral became nearly worthless. In 2020, "Black Thursday" on Ethereum saw network congestion prevent MakerDAO's liquidations, resulting in millions in bad debt that was later covered by auctioning the protocol's MKR governance token. These events highlight how bad debt is not just an isolated accounting loss but a threat to a protocol's solvency and user confidence, often requiring emergency governance votes and changes to risk parameters to resolve.

Bad debt in DeFi is an insolvent loan position where the value of the collateral backing a loan falls below the loan's value, and the position cannot be profitably liquidated to repay the lender. This occurs when a borrower's collateral asset experiences a severe and rapid price decline, often during a market crash or a liquidity crisis. The core mechanism relies on overcollateralization, where loans are only issued if the collateral value exceeds the loan value by a safety margin (the collateral factor or loan-to-value ratio). When asset prices fall, this margin erodes, triggering automatic liquidations.

The formation of bad debt is typically a failure of the liquidation process. For a liquidation to be successful, a liquidator must be incentivized to repay part or all of the undercollateralized debt in exchange for the collateral at a discount. Bad debt accrues when this mechanism breaks down due to: - Insufficient liquidation incentives (discount is too small), - Network congestion delaying critical transactions, - A lack of liquidators with available capital, or - Zero liquidity for the collateral asset on decentralized exchanges, making it impossible to sell. During these conditions, the underwater position remains open, creating a deficit for the lending protocol.

A classic example is the "liquidation spiral" during the May 2022 collapse of the Terra/LUNA ecosystem. As the price of UST depegged and LUNA collapsed, billions in loans backed by these assets became severely undercollateralized. The sheer volume of liquidations overwhelmed the network and available liquidity, causing the oracle prices to lag and liquidation bots to fail. The protocol was left with massive bad debt, as the value of the seized collateral was far less than the outstanding stablecoin loans. This event demonstrated how oracle failure and market illiquidity are primary catalysts.

Protocols manage this risk through parameters like liquidation thresholds, health factors, and liquidation bonuses. Some maintain insurance funds or treasury reserves to cover bad debt shortfalls, socializing the loss among token holders. However, these are reactive measures. The inherent, unavoidable cause of bad debt is extreme market volatility combined with the immutable and automated nature of smart contracts, which cannot adjust terms or offer forbearance like a traditional bank.