Bad Debt

The core condition of bad debt is when the value of a borrowed position's collateral falls below the value of the loan plus accrued interest. This creates a negative equity position for the protocol. Key triggers include:

• Asset price volatility causing collateral value to plummet.
• Oracle failure providing stale or manipulated price data.
• Liquidation inefficiency where liquidators cannot profitably close the position before it becomes underwater.

Bad debt is a direct liability on the protocol's balance sheet. It represents value that is owed to lenders (depositors) but is not backed by sufficient collateral. The protocol must absorb this loss, typically by:

• Socializing losses across all users (e.g., minting protocol tokens to cover the shortfall).
• Using a treasury or insurance fund to make lenders whole.
• Allowing the debt to remain as a persistent, unresolved obligation on its books.

Unresolved bad debt acts as a contagion risk. If a major lending protocol like Aave or Compound accrues significant bad debt, it can trigger a loss of confidence, leading to:

• Bank runs as users rush to withdraw funds.
• Downward pressure on native governance tokens used as collateral or for loss absorption.
• Spillover effects to interconnected protocols and the broader DeFi ecosystem, as seen in events like the LUNA/UST collapse.

Protocols use specific mechanisms to quantify and address bad debt. Health Factor or Collateral Ratio metrics signal at-risk positions. Resolution methods include:

• Liquidation: The primary defense, where a position is forcibly closed by a third-party liquidator for a bonus.
• Debt Auctions: Protocols like MakerDAO auction off collateralized debt positions (CDPs) or mint MKR to cover deficits.
• Recapitalization: Using protocol-owned revenue or treasury assets to directly repay the bad debt.

A canonical example occurred on March 12, 2020 ("Black Thursday"), when ETH prices crashed over 30%. On the MakerDAO protocol:

• Network congestion prevented timely liquidations.
• Undercollateralized Vaults: Over 2,000 ETH vaults were liquidated for zero DAI due to a flawed auction mechanism.
• Bad Debt Created: The system was left with $4.5 million in bad debt, which was later covered by minting and auctioning new MKR tokens.

The centralized crypto lender collapsed due to a fatal combination of undercollateralized loans, risky investments, and a bank run. The company filed for Chapter 11 bankruptcy with a deficit exceeding $1.2 billion on its balance sheet.

• Core Failure: Over-the-Counter (OTC) lending to institutional clients without sufficient collateral.
• Contagion: Its insolvency triggered massive bad debt across interconnected DeFi protocols where Celsius was a major borrower.
• Legacy: This event became a textbook case of maturity mismatch and counterparty risk in crypto finance.

A decentralized algorithmic stablecoin project (IRON) experienced a death spiral when its partial-collateralization model failed under selling pressure. The TITAN governance token, which backed the stablecoin's uncollateralized portion, crashed to zero, rendering IRON redeemable only for its collateral portion and creating massive bad debt for holders.

• Mechanism: The protocol relied on arbitrage to maintain peg; panic selling broke the feedback loop.
• Result: IRON lost its peg, and the TITAN token collapsed, wiping out the protocol equity meant to absorb losses.

This institutional lending protocol suffered significant bad debt when major borrowing entities, including the crypto hedge fund Orthogonal Trading, defaulted on loans. A single pool managed by M11 Credit faced $36 million in unrecoverable loans.

• Context: Loans were extended to institutional borrowers during the bull market with off-chain legal agreements.
• Trigger: The FTX collapse revealed borrower insolvency.
• Impact: The bad debt was borne by pool lenders, highlighting the underwriting risk in permissioned DeFi pools.

When the LUNA and UST ecosystem collapsed, it created $270 million in bad debt for the Venus lending protocol on BNB Chain. The debt arose because large positions using LUNA as collateral became nearly worthless before they could be liquidated.

• Cause: LUNA's price fell >99.9% in days, breaching liquidation thresholds faster than the liquidation system could operate.
• Resolution: The Venus community voted to use the protocol's Treasury and a token sale to cover a significant portion of the bad debt, preventing insolvency.

Bad debt occurs when the value of a borrower's collateral falls below their outstanding loan value, and the position cannot be liquidated in time. This creates a shortfall where the protocol's liabilities exceed its assets. Key mechanisms include:

• Undercollateralization: Collateral value drops faster than liquidation bots can act.
• Liquidation Failure: Due to network congestion, lack of liquidators, or design flaws in the liquidation engine.
• Protocol Insolvency: The bad debt becomes a permanent liability on the protocol's balance sheet.

Bad debt typically arises from a confluence of market and protocol-specific failures.

• Extreme Market Volatility: Rapid, flash-crash style price drops in collateral assets (e.g., LUNA/UST collapse).
• Oracle Failure/Delay: Stale or manipulated price feeds prevent accurate valuation of collateral.
• Insufficient Liquidation Incentives: Liquidator rewards are too low relative to gas costs or slippage risks.
• Design Flaws: Inadequate liquidation thresholds, health factor calculations, or over-reliance on a single, volatile collateral type.

Unresolved bad debt directly threatens protocol solvency and user funds.

• Loss Absorption: Protocols often use a safety module or insurance fund to cover initial shortfalls.
• Socialized Losses: If reserves are exhausted, losses may be socialized among all lenders via debt auctions, token inflation, or haircuts on withdrawable funds.
• Reputational Damage: Erodes trust in the protocol's risk management, leading to capital outflows.
• Regulatory Scrutiny: Highlights systemic risks within the DeFi lending landscape.

Protocols employ multiple layers of defense to prevent and manage bad debt.

• Conservative Risk Parameters: High collateralization ratios, low loan-to-value (LTV) limits for volatile assets.
• Robust Oracle Design: Using multiple, decentralized price feeds with delay and staleness checks.
• Dynamic Liquidation Incentives: Liquidation bonuses that scale with risk and network conditions.
• Protocol-Owned Reserves: Maintaining a well-capitalized treasury or insurance fund as a backstop.
• Debt Auctions: Mechanisms like MakerDAO's flip and flap auctions to recapitalize the system.

Real-world incidents provide critical lessons in bad debt formation.

• MakerDAO (March 2020): $5.6 million in bad debt created during the "Black Thursday" ETH price crash due to network congestion and 0 DAI bids in auctions.
• Venus Protocol (May 2021): A coordinated pump of XVS collateral led to massive borrowing and subsequent bad debt when the price collapsed.
• Cream Finance (2021 Exploits): Multiple flash loan attacks exploited price oracle manipulations to create bad debt and drain protocol reserves.

Bad debt is interconnected with other critical DeFi risk vectors.

• Liquidity Risk: The inability to exit a position or liquidate collateral without significant slippage.
• Counterparty Risk: In decentralized lending, this is transformed into smart contract risk and oracle risk.
• Systemic Risk: Bad debt in one major protocol can cascade through interconnected money markets and stablecoins.
• Insolvency vs. Illiquidity: A key distinction; a protocol may be temporarily illiquid but solvent, whereas bad debt implies insolvency without intervention.

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). This is the primary mechanism for preventing bad debt.

• Triggered by: Price volatility, collateral devaluation, or debt increase.
• Liquidation Penalty: A fee charged to the borrower to incentivize liquidators.
• Failure: If liquidation is impossible (e.g., no liquidators, illiquid collateral), the position becomes underwater and creates bad debt.

A numerical representation of a loan's safety margin, calculated as (Collateral Value * Liquidation Threshold) / Borrowed Value. It is the core metric for monitoring loan risk.

• HF > 1: Position is considered safe.
• HF <= 1: Position is eligible for liquidation.
• HF << 1: Position is severely underwater, indicating high risk of bad debt if liquidation fails.

A loan where the value of the borrowed assets exceeds the value of the posted collateral, rendering it insolvent. This is the immediate precursor to bad debt.

• Cause: A sharp drop in collateral value or a failed liquidation event.
• Result: The protocol's liabilities exceed its assets for that position.
• Resolution: May be absorbed by a protocol treasury or insurance fund, or socialized among lenders.

The maximum percentage of a collateral asset's value that can be borrowed against. It is a key risk parameter set by a lending protocol.

• Example: An LTV of 75% for ETH means you can borrow up to $0.75 for every $1 of ETH collateral.
• Purpose: Creates a buffer against price volatility to protect against bad debt.
• Risk Management: Lower LTV ratios for volatile assets reduce systemic bad debt risk.

A capital reserve, often funded by protocol fees or token staking, designed to cover losses from bad debt and failed liquidations.

• Function: Acts as a backstop to make lenders whole when collateral is insufficient.
• Mechanism: May use staked native tokens (e.g., AAVE's Safety Module) or a dedicated treasury.
• Outcome: Protects protocol solvency and user funds, but dilutes value for stakers or fee recipients.

The collateral value ratio at which a position becomes eligible for liquidation. It is distinct from and higher than the Loan-to-Value (LTV) ratio.

• Example: An asset with 80% LTV and 85% liquidation threshold has a 5% safety buffer before liquidation.
• Purpose: Ensures liquidations begin while enough collateral value remains to cover the debt and penalty, minimizing bad debt risk.