Loss Given Default (LGD)

Loss Given Default (LGD) is the percentage of an outstanding loan or credit exposure that is not recovered after a borrower defaults. It is a core component of credit risk models, calculated as:

LGD = 1 - Recovery Rate

• Recovery Rate: The proportion of the defaulted amount reclaimed through collateral liquidation, insurance, or other mechanisms.
• In traditional finance, LGD is estimated historically. In DeFi, it can be modeled in real-time based on collateral ratios and liquidation engine efficiency.

In protocols like Aave and Compound, LGD is intrinsically linked to collateralization ratios and liquidation mechanisms. A loan's potential LGD is near zero if it is overcollateralized and the liquidation process is efficient. However, LGD becomes a real risk in scenarios involving:

• Undercollateralized Lending: As seen in credit delegation or "credit gating" models.
• Liquidation Inefficiency: During network congestion or volatile markets, liquidations may fail, leading to bad debt and a high LGD for the protocol.

LGD is one half of the Expected Loss (EL) equation, paired with Probability of Default (PD).

Expected Loss (EL) = Exposure at Default (EAD) × PD × LGD

• PD: Estimates the likelihood a borrower will default.
• EAD: The total value at risk at the time of default.
• This framework allows protocols and analysts to model aggregate risk pools, price credit, and size insurance reserves accurately.

Protocols specializing in uncollateralized credit, such as Maple Finance or Goldfinch, explicitly model and manage LGD. Their risk assessment involves:

• Pool Delegates: Entities that underwrite loans and bear first-loss capital, directly impacting the pool's LGD.
• Coverage Ratios: Staked capital that acts as a buffer against defaults, effectively reducing the LGD for senior lenders.
• Recovery Processes: Legal and on-chain mechanisms to reclaim funds post-default.

These are inverse, complementary metrics crucial for post-default analysis.

• Recovery Rate: The percentage of the defaulted exposure that is successfully recovered (e.g., 40%).
• Loss Given Default: The percentage that is lost (e.g., 60%).

In DeFi, the recovery rate is determined by:

• Collateral Liquidation Value: Market price at time of sale.
• Liquidation Penalties: Fees paid to liquidators.
• Protocol Treasury Reserves: Used to cover shortfalls, affecting the ultimate loss.

Accurate LGD estimation in DeFi is highly dependent on oracle reliability and liquidity depth.

• Price Oracles: Provide the asset valuations used to trigger liquidations. Oracle failure or manipulation can lead to incorrect collateral valuation and higher LGD.
• Liquidity Oracles: Assess the available market depth to liquidate large positions without significant slippage, which directly impacts the recovery rate.
• Models must stress-test these dependencies under extreme market conditions.

LGD is intrinsically linked to the Recovery Rate (1 - LGD). In DeFi, this is primarily determined by collateralization ratios and liquidation mechanisms. A well-collateralized loan with a high Loan-to-Value (LTV) buffer and efficient liquidations aims for a near-zero LGD. Key factors include:

• Collateral Volatility: Highly volatile assets increase potential LGD if prices crash before liquidation.
• Liquidation Efficiency: Delays or failed liquidations due to network congestion or oracle lag can drastically increase LGD.
• Haircuts: The discount applied to collateral value during liquidation directly impacts the final recovery amount.

LGD is not a fixed observable value but an estimated parameter, introducing model risk. Using historical averages or simplistic assumptions can lead to significant mispricing of risk. Considerations include:

• Cycle Dependency: LGD tends to spike during market downturns when collateral values fall and liquidations cluster, a phenomenon known as wrong-way risk.
• Protocol-Specific Factors: Unique smart contract logic, governance parameters (e.g., liquidation penalties, grace periods), and the design of stability mechanisms all influence realized LGD.
• Data Scarcity: Limited default history in nascent DeFi markets makes robust statistical estimation challenging.

LGD is a core component of regulatory and internal capital frameworks. Under the Basel Accords, Expected Loss (EL) is calculated as EL = PD × LGD × EAD (Probability of Default × Loss Given Default × Exposure at Default). In DeFi, this translates to:

• Protocol Solvency: Accurate LGD is essential for determining the necessary size of insurance funds or shared loss pools (e.g., MakerDAO's Surplus Buffer).
• Risk-Adjusted Returns: Lenders and liquidity providers must model LGD to calculate true yield after accounting for expected defaults.
• Stress Testing: Scenarios must shock LGD parameters alongside PD and collateral values to assess protocol resilience.

Protocols architect security to minimize LGD through layered defenses:

• Over-collateralization: The primary defense, setting conservative LTV ratios.
• Liquidation Incentives: Designing robust incentive auctions (e.g., Dutch, English) to ensure bad debt is covered.
• Grace Periods & Keepers: Implementing mechanisms like health factor warnings and decentralized keeper networks to trigger liquidations proactively.
• Recovery Modules: Protocols like Aave V3 include an Isolated Mode to contain risk and a formal Recovery Phase for managing insolvent positions, explicitly defining the LGD process.

LGD must be understood in context with other key risk measures:

• Probability of Default (PD): The likelihood a borrower fails to meet obligations. LGD defines the severity given that default occurs.
• Exposure at Default (EAD): The total value at risk at the moment of default. LGD is applied to this amount.
• Credit Valuation Adjustment (CVA): The market value of counterparty credit risk, derived from PD and LGD.
• Expected Loss (EL): The foundational risk metric: EL = PD × LGD × EAD. It represents the average loss anticipated over time.

The Probability of Default (PD) is the estimated likelihood that a borrower will fail to meet their debt obligations within a specific time horizon. It is a forward-looking metric, typically expressed as a percentage. PD and LGD are the two primary inputs for calculating Expected Loss (EL), where EL = PD × LGD × Exposure at Default (EAD). While PD measures the chance of a default occurring, LGD measures the severity of the loss if it does.

Exposure at Default (EAD) is the total value at risk when a borrower defaults. It represents the outstanding claim a lender has at the moment of default. In the Expected Loss (EL) formula (EL = PD × LGD × EAD), EAD is the base amount to which the loss rate (LGD) is applied. In DeFi, this could be the principal + accrued interest on a loan, the total value of assets in a liquidity pool at risk from an exploit, or the notional value of a derivative contract.

Expected Loss (EL) is the anticipated average credit loss over a given period, calculated as the product of three key risk parameters: Probability of Default (PD), Loss Given Default (LGD), and Exposure at Default (EAD). The formula is: EL = PD × LGD × EAD. It represents a cost of doing business that financial institutions and DeFi protocols provision for. EL is a critical metric for pricing loans, setting capital reserves, and managing overall portfolio risk.

The Recovery Rate is the proportion of the Exposure at Default (EAD) that is recovered after a default occurs, typically through collateral liquidation, restructuring, or legal proceedings. It is the direct complement to Loss Given Default (LGD). The relationship is: Recovery Rate = 1 - LGD. For example, an LGD of 40% implies a Recovery Rate of 60%. In secured lending, the recovery rate is heavily dependent on the quality and liquidation process of the collateral.

Credit Valuation Adjustment (CVA) is the monetary value of the credit risk of a counterparty in a derivatives transaction or other contract. It represents the market value of the potential future loss due to the counterparty's default. CVA calculation incorporates the Probability of Default (PD), Loss Given Default (LGD), and the exposure profile over time. It is a critical adjustment to the risk-free value of a contract and is a key concept in institutional finance and increasingly relevant for on-chain derivatives and perpetual futures protocols.

The Collateralization Ratio (or Collateral Factor) is a primary risk parameter in secured lending that directly influences Loss Given Default (LGD). It is the ratio of the value of collateral posted to the value of the loan issued (e.g., 150%). A higher ratio provides a larger buffer against collateral value volatility, reducing the LGD in the event of a default and liquidation. In DeFi lending protocols like Aave and Compound, minimum collateralization ratios are enforced by smart contracts to manage systemic risk and potential losses.