Bad Debt

Bad debt is a loan position where the value of the borrowed assets exceeds the value of the posted collateral, and the borrower is unable or unwilling to repay or add more collateral. This occurs when:

• Asset prices drop sharply, causing undercollateralization.
• The liquidation mechanism fails to close the position in time.
• The protocol's liquidation engine cannot find a liquidator due to network congestion or insufficient incentives.

Bad debt typically arises from a combination of market conditions and protocol design factors.

• Extreme Market Volatility: Rapid price declines in collateral assets (e.g., a "black swan" event) can outpace liquidations.
• Liquidation Inefficiency: Delays due to network congestion, low liquidation incentives, or a lack of liquidators.
• Oracle Failure/Manipulation: If the price oracle provides stale or incorrect data, the protocol may not trigger liquidations when needed.
• Concentrated Collateral Risk: Over-reliance on a single volatile asset as collateral increases systemic vulnerability.

Unresolved bad debt directly threatens a lending protocol's solvency and user trust.

• Insolvency Risk: The protocol's liabilities (user deposits) exceed its assets if bad debt is not covered.
• Loss Socialization: Some protocols use a global settlement or recapitalization process, where losses are shared among all depositors or token holders.
• Reserve Drain: Protocols may use a safety module or treasury reserves to absorb the losses, depleting backstop funds.
• Reputational Damage: Persistent bad debt erodes confidence, leading to reduced Total Value Locked (TVL) and usage.

Protocols implement several defenses to prevent and manage bad debt.

• Conservative Collateral Factors: Higher loan-to-value (LTV) ratios require more overcollateralization, creating a larger safety buffer.
• Robust Liquidation Systems: Efficient bots, sufficient liquidation bonuses, and auction mechanisms to ensure positions are closed.
• Diversified Collateral: Supporting a wide range of assets reduces concentration risk.
• Debt Auctions & Recapitalization: Mechanisms like MakerDAO's surplus auctions or MKR minting to recapitalize the system.
• Risk Parameters: Dynamic adjustment of liquidation thresholds and liquidation penalties based on market conditions.

Bad debt is quantified as the dollar value of loans that are undercollateralized and unrecoverable. Notable historical examples include:

• MakerDAO (March 2020): Approximately $4 million in bad debt was created during the "Black Thursday" crash due to network congestion preventing liquidations. This was later covered by auctioning off the protocol's MKR token.
• Venus Protocol (May 2021): A market manipulation incident involving the CAN token as collateral led to over $200 million in bad debt, resolved through negotiations and a treasury grant.
• Celsius & BlockFi (2022): Centralized lending platforms that failed due to massive, undisclosed bad debt from uncollateralized loans to institutional clients.

Understanding bad debt requires familiarity with interconnected DeFi mechanisms.

• Insolvency: The state where a protocol's liabilities exceed its assets.
• Undercollateralized Loan: A loan where the collateral value falls below the required threshold, a precursor to bad debt.
• Liquidation: The process of automatically selling a borrower's collateral to repay their loan, intended to prevent bad debt.
• Health Factor / Collateral Ratio: The metric that determines when a position becomes eligible for liquidation.
• Protocol-Controlled Value (PCV) / Treasury: Reserve funds that may be used to cover bad debt shortfalls.

Rapid, large price drops in the collateral asset can cause a loan to become undercollateralized before a liquidation is triggered or executed. This is exacerbated by oracle latency, where the price feed used by the protocol lags behind the real market price on exchanges, creating a window where the collateral value is mispriced.

• Example: A 30% flash crash in ETH price might make a loan undercollateralized, but if the oracle updates slowly, liquidators cannot act in time.

Liquidators are incentivized by a liquidation bonus (or penalty) taken from the borrower's collateral. If this bonus is too small, it may not cover the liquidator's gas fees and slippage risk, especially during network congestion or in illiquid markets. Without active liquidators, underwater positions remain open, accruing more debt.

• This creates a bad debt hole that grows until the protocol's insurance or treasury must cover it.

Loans backed by a single, volatile asset or illiquid collateral (e.g., long-tail tokens with low trading volume) are high-risk. During a market downturn:

• Slippage: Selling large amounts of illiquid collateral depresses its price further, potentially not covering the debt.
• Concentration Risk: A protocol overly exposed to one collapsing asset (like LUNA/UST) can see systemic bad debt accumulate instantly across many positions.

Technical failures in the liquidation process can prevent debt from being cleared. This includes:

• Smart contract bugs or exploits that disable liquidation functions.
• Oracle failure or manipulation providing incorrect prices.
• Network congestion (high gas prices) that makes liquidation transactions economically unviable or too slow. These failures leave the protocol with no automated way to resolve undercollateralized positions.

Complex DeFi leverage cycles can amplify risk. A common pattern involves using borrowed assets as collateral to borrow more (recursive lending). When the price of the base collateral falls, it triggers a cascade of liquidations across interconnected positions, overwhelming the system's liquidity and creating bad debt faster than it can be processed.

• This was evident during the 2022 "DeFi Summer" crash and the collapse of the UST stablecoin.

When a collateralized debt position (CDP) is backed by or denominated in a stablecoin that loses its peg (e.g., falls to $0.90), the fundamental accounting of the loan breaks.

• If the borrowed asset is a depegged stablecoin, the debt's dollar value is unclear.
• If the collateral is a depegged stablecoin, its value as security plummets. This can instantly create massive, unmanageable bad debt across a protocol, as seen with UST serving as major collateral on Anchor Protocol.

The primary defense against bad debt. It requires borrowers to deposit collateral worth more than the loan value, creating a safety buffer against price volatility. Key aspects include:

• Loan-to-Value (LTV) Ratios: The maximum percentage of collateral value that can be borrowed (e.g., 75% LTV).
• Maintenance Margin: The minimum collateral ratio a position must maintain before facing liquidation.
• Collateral Factors: Risk-adjusted discounts applied to different asset types based on their volatility and liquidity.

A critical safety mechanism that automatically sells a borrower's collateral when their health factor falls below a threshold (e.g., 1.0), repaying the debt before it becomes undercollateralized. This process involves:

• Liquidation Triggers: Monitors collateral value in real-time via price oracles.
• Liquidation Incentives: Liquidators are rewarded with a liquidation bonus (a discount on the collateral) for closing risky positions.
• Auction Mechanisms: Some protocols use Dutch or English auctions to maximize collateral recovery.

Protocols manage risk exposure through configurable parameters controlled by governance. These are the primary levers for mitigating bad debt:

• Asset Listing Criteria: Strict due diligence on collateral types, assessing volatility and market depth.
• Dynamic Parameter Adjustment: LTV ratios, liquidation thresholds, and bonus rates can be updated in response to market conditions.
• Debt Ceilings: Caps on the total amount that can be borrowed against a specific collateral asset to limit concentrated risk.

Accurate, tamper-resistant price feeds are essential to prevent bad debt from oracle manipulation or stale data. Common solutions include:

• Decentralized Oracle Networks: Aggregating price data from multiple independent sources (e.g., Chainlink).
• Time-Weighted Average Prices (TWAPs): Using price averages over a period to smooth out short-term manipulation.
• Circuit Breakers: Pausing borrowing/liquidation if oracle prices deviate significantly from the broader market.

Backstop solutions designed to absorb losses if bad debt occurs, protecting depositors. These include:

• Protocol-Owned Reserves: A treasury fund, often filled with protocol revenue, used to cover shortfalls.
• Insurance/Staking Pools: Users can stake native tokens (e.g., Aave's Safety Module) to act as a capital backstop in exchange for rewards.
• DeFi Insurance Protocols: Third-party coverage where users can purchase policies against smart contract failure or specific insolvency events.

Understanding how bad debt typically occurs helps in designing better prevention. Classic scenarios include:

• Flash Loan Attacks: Manipulating oracle prices or liquidity pools to trigger unjust liquidations or avoid legitimate ones.
• Collateral Volatility: Extreme, rapid market crashes that outpace the liquidation system's ability to respond.
• Liquidity Crises: A lack of liquidators or market depth for the collateral asset, causing failed liquidations.
• Smart Contract Exploits: Bugs that disable core mechanisms like price updates or liquidation logic.

A numerical representation of a loan's safety margin, calculated as the ratio of the collateral value to the borrowed value. It determines the proximity to liquidation.

• Formula: (Total Collateral Value in USD * Liquidation Threshold) / Total Borrowed Value in USD.
• >1: Loan is considered safe.
• <=1: Loan becomes eligible for liquidation.
• A health factor dropping to or below 1 without successful liquidation directly creates bad debt.

A loan where the market value of the collateral is less than the value of the borrowed assets plus accrued interest. This is the precise state that defines bad debt.

• Cause: Collateral value crashes faster than liquidation can occur.
• Consequence: The loan is insolvent; the protocol cannot recover the full loan value from the collateral sale.
• Protocol Impact: Losses are typically socialized among lenders or covered by a safety module or treasury.

A critical data feed that provides the current market price of collateral and debt assets to the protocol. Accurate, timely oracles are essential for preventing bad debt.

• Function: Determines collateral value for health factor calculations and liquidation triggers.
• Risk: Oracle manipulation or failure (e.g., stale price) can cause incorrect health factors, preventing necessary liquidations or triggering unnecessary ones.
• Solution: Protocols use decentralized oracle networks (e.g., Chainlink) with price feeds and circuit breakers.