Bad Debt

Bad debt occurs when a loan's outstanding value exceeds the liquidation value of its collateral, creating a deficit that cannot be recovered through automated protocols. This happens when:

• Collateral value plummets faster than liquidation bots can act.
• Liquidity dries up, making it impossible to sell the collateral at a fair price.
• The resulting shortfall is a permanent loss absorbed by the lending protocol's reserves or insurance fund.

Unlike traditional finance, DeFi bad debt is often transparent and protocol-wide. It represents a state where the protocol's total liabilities exceed its realizable assets. This is visible on-chain and can erode user confidence, as seen in events like the Iron Bank's CREAM Finance incident, where bad debt accumulated from multiple undercollateralized positions.

Bad debt in one protocol can spread risk across the ecosystem through interconnected lending and borrowing. For example, if Protocol A uses a token from Protocol B as collateral, bad debt in Protocol A can devalue that token, potentially triggering insolvency in Protocol B. This creates a domino effect, amplifying the original loss.

A primary cause of bad debt is the exploitation of price feed oracles. Attackers can artificially inflate the value of collateral via oracle manipulation (e.g., flash loan attacks on DEX pools), borrow excessively against it, and leave the protocol with worthless collateral. This directly creates bad debt from fabricated asset valuations.

Bad debt risk is highest for loans backed by low-liquidity or volatile assets. Even if collateral is technically sufficient, a lack of market depth prevents liquidators from selling large positions without significant price slippage. This can turn a theoretically safe loan into bad debt during a market crash, as liquidations fail to cover the debt.

Protocols employ specific mechanisms to handle bad debt, including:

• Insurance funds (e.g., Aave's Safety Module) to cover shortfalls.
• Recapitalization through token sales or governance votes.
• Socialized losses, where the cost is distributed among all users, often via debt tokens that represent a claim on future protocol revenue.

Bad debt accrues when a borrower's collateral value falls below the required loan-to-value (LTV) ratio, but the liquidation process fails to cover the debt. This occurs due to:

• Insufficient Liquidity: No liquidators are available to buy the collateral at the current price.
• Oracle Latency/Manipulation: Price feeds are stale or inaccurate, preventing timely liquidations.
• Collateral Illiquidity: The collateral asset itself cannot be sold without causing massive slippage, making the liquidation unprofitable.

Rapid, large price movements can outpace protocol safeguards. A flash crash or black swan event can cause collateral value to plummet before liquidations can be executed, instantly creating underwater positions. This is especially acute with volatile collateral assets like memecoins or leveraged tokens.

Protocol vulnerabilities can be exploited to deliberately create bad debt. Common vectors include:

• Oracle Manipulation: Artificially inflating or deflating the reported price of collateral to trigger incorrect loans or avoid liquidation.
• Logic Bugs: Flaws in interest accrual, fee calculation, or liquidation logic that prevent debt from being properly settled.
• Governance Attacks: Malicious governance proposals that alter critical parameters (like LTV ratios) to destabilize the system.

When a lending protocol is over-exposed to a single, correlated asset class, a sector-wide downturn can trigger mass liquidations simultaneously. This overwhelms the liquidation system and market depth. Examples include protocols heavily weighted toward a specific L1 token or a basket of similar DeFi governance tokens.

If borrowing demand surges but supply is insufficient, variable interest rates can spike exponentially. For long-term loans, this can cause the accruing interest to exceed the collateral value over time, especially if the collateral's price is stagnant or declining. The debt becomes economically unviable to repay.

Bad debt can propagate through the interconnected DeFi ecosystem. A failure in one protocol (Protocol A) can deplete its liquidity, causing its native token (used as collateral in Protocol B) to crash. This then triggers insolvencies in Protocol B, creating a cascade of bad debt across multiple platforms.

The automated process of selling a borrower's collateral to repay their loan when their health factor falls below a threshold (e.g., 1.0). It is the primary defense against bad debt. Failure modes include:

• Insufficient Liquidity: No buyers for the collateral asset at any price.
• Oracle Failure: Price feed lag or manipulation prevents timely triggering.
• Gas Price Spikes: Liquidator transactions are outbid by network congestion.

A risk metric representing the safety of a collateralized debt position (CDP). It is calculated as (Collateral Value * Liquidation Threshold) / Debt Value.

• HF > 1: Position is safe.
• HF <= 1: Position is subject to liquidation.
• HF << 1: Position is underwater; if unliquidated, it becomes bad debt. Protocols monitor aggregate HF to gauge systemic risk.

The state where a borrower's debt exceeds the recoverable value of their collateral. In DeFi, this is the technical definition of bad debt. It occurs post-liquidation failure. The protocol's balance sheet now holds an asset (the debt) with no backing value, creating a liability that may be socialized among users or covered by a treasury or insurance fund.

The maximum loan-to-value (LTV) ratio at which a position can be liquidated, set per collateral asset by the protocol's risk parameters. For example, a threshold of 80% for ETH means a loan becomes liquidatable if the debt reaches 80% of the collateral's value. A lower threshold provides a larger safety buffer for liquidators, reducing bad debt risk.

A recovery mechanism used by protocols like MakerDAO to recapitalize the system after bad debt is realized. The protocol mints and auctions off its native governance token (e.g., MKR) in exchange for stablecoins (e.g., DAI) to cover the bad debt. This process transfers the cost to token holders via dilution, restoring the protocol's solvency.

A collateralized debt position where the market value of the debt is greater than the market value of the collateral (Debt > Collateral). This is a pre-insolvency state. If the position is not liquidated while Health Factor > 1, a sudden price drop can push it underwater instantly, making liquidation unprofitable and locking in bad debt.