Bad Debt

Bad debt in a lending protocol is a loan whose collateral is worth less than what is owed, with no mechanism left to recover the difference. It is the failure the whole design of overcollateralisation exists to prevent: positions are meant to be liquidated while the collateral still covers the debt, leaving the pool whole. Bad debt appears when that liquidation does not happen in time — a price falls faster than liquidators can act, gas costs or thin liquidity make a liquidation unprofitable to perform, or an oracle reports a price that is stale or manipulated. Once it exists, the shortfall belongs to the pool, which means to the depositors, and it is usually socialised across them unless the protocol holds a reserve for exactly this. Whether a protocol has a backstop, how large it is, and who decides its use are the questions the term points at.