Bad Debt

What is bad debt, and how does it differ from what people typically think of as an 'investment loss'?

Bad debt refers to a situation in an over-collateralized lending protocol where a borrowed position's collateral's actual market value has fallen below the amount owed on that loan, meaning even fully liquidating the collateral wouldn't be enough to repay the corresponding debt. Since the over-collateralization mechanism was originally designed to require collateral value to 'exceed' the borrowed amount (say, collateralizing $150 to borrow only $100), this buffer space under normal conditions should be enough to handle price volatility, giving the liquidation mechanism a chance to close out the position before collateral value falls below the borrowed amount. Bad debt appearing means this buffer mechanism failed at some particular moment.

The key difference from what's typically thought of as an 'investment loss' lies in 'who bears the loss': a typical investment loss is usually borne by the investor themselves — however much they lose is their own affair, with no direct spillover to others; bad debt is different — once a borrowed position develops bad debt, this gap doesn't just vanish, it needs to be absorbed by the protocol's overall assets (usually from the pool jointly held by depositors), meaning other depositors who never directly participated in that specific loan transaction could still bear an indirect loss because of this bad debt. This is also why bad debt is considered one of the most seriously regarded systemic risks in a lending protocol.

Why does bad debt happen, and what are the underlying causes?

A few common bad debt causes:

1. Extreme price volatility exceeding the liquidation mechanism's reaction speed: if a collateral asset crashes sharply within an extremely short window (such as the flash crash covered in an earlier article), the liquidation mechanism might not complete closing out the position in time before collateral value falls below the borrowed amount — especially under severe network congestion where liquidation transactions can't confirm on-chain promptly, this risk gets further amplified
2. Delayed liquidation from insufficient liquidation incentive: if a protocol's set liquidation bonus is too low, or current market gas cost is too high, a liquidator might find executing liquidation not worthwhile and choose to skip it, letting a position that should have been liquidated remain on-chain continuing to accumulate losses
3. Insufficient collateral liquidity itself: even when the liquidation mechanism triggers normally, if the asset serving as collateral has extremely shallow liquidity in the market, a liquidator attempting to sell a large amount of this collateral could see actual cash-out amount fall far below book value due to slippage, effectively creating bad debt
4. Oracle price inaccuracy: if a protocol's relied-upon price oracle itself has a delay or is manipulated (the oracle manipulation attack covered in an earlier article), the liquidation mechanism might act on an incorrect price judgment, failing to trigger liquidation at the right moment — by the time price information corrects, collateral's actual value has already fallen below the borrowed amount

These causes frequently stack together — a genuinely severe bad debt incident is often not caused by a single reason, but the result of multiple points failing simultaneously.

After bad debt appears, how does a protocol typically handle it, and what does the specific handling process look like?

A typical bad debt handling process involves several stages:

1. Confirmation and calculation: a protocol first needs to confirm the specific bad debt amount — calculating the precise gap size from the difference between assets actually recovered through liquidation and the borrowed amount originally owed
2. Prioritizing deployment of the insurance fund: if a protocol has an insurance fund as covered in an earlier article, the first line of defense is usually deploying this fund to cover the gap — the most ideal handling approach by design, since depositors don't need to bear any direct loss
3. Subsequent handling when the insurance fund is insufficient: if the bad debt scale exceeds what the insurance fund can cover, a protocol usually needs to decide the subsequent plan through a governance vote, with common options including: minting additional shares of the protocol's own governance token, raising funds through a market sale to cover the gap (diluting all token holders' stake); deploying other reserve assets in the protocol treasury; or the least ideal scenario — proportionally having all depositors jointly share the gap, meaning even if your deposit was never involved in that particular problematic loan transaction, you might still be asked to bear a portion of the loss
4. Post-mortem review and mechanism adjustment: most responsible protocols, after handling a bad debt incident, publish a post-mortem report specifically explaining the root cause behind the bad debt and adjust relevant parameters accordingly (such as raising a specific asset's liquidation bonus, or tightening collateralization ratio requirements), to avoid a similar incident recurring

Whether this entire process can proceed smoothly and whether the handling outcome is fair and reasonable largely depends on how mature and transparent the protocol's governance mechanism is.

What's the practical impact of bad debt on everyday users, and how should this risk be assessed before depositing?

For a depositor, bad debt's most direct risk is: even if your own deposit operation is entirely normal and never involved any problematic loan transaction, you could still bear a loss where your principal can't be redeemed in full because the protocol overall developed bad debt — this 'collective liability' nature of risk is an inherent characteristic of the over-collateralized lending protocol's shared-pool model, and a systemic factor that must be seriously considered when assessing any lending protocol.

A few concrete indicators worth verifying before depositing: what types of collateral assets this protocol supports, and how volatile and liquid they are — the more diverse the supported assets, and the more it includes extremely volatile or shallow-liquidity long-tail assets, the higher overall bad debt risk usually runs; how mature the protocol's liquidation mechanism design is, including whether the liquidation bonus is reasonably set and whether it adopts a manipulation-resistant oracle design (such as the TWAP mechanism covered in an earlier article); whether the protocol has an insurance fund as its first line of defense, and whether this fund's ratio relative to the protocol's overall risk exposure is sufficient; and whether the protocol has ever experienced a bad debt incident before — if so, whether it was handled fairly and transparently afterward, and whether concrete mechanism adjustments addressing the root cause were made. Adding up these details reflects the genuine safety of your principal under extreme conditions far better than simply looking at the displayed deposit APY.