Ever heard or read about bad debt when reading finance news or listening to a cryptocurrency podcast. This article answers all your questions about the matter.
A bad debt in a crypto lending protocol like Venus Finance, AAVE Protocol or Compound Finance occurs when a borrower is unable to repay their loan, and the protocol cannot fully recover the loan amount by liquidating the borrower’s collateral. Here’s what it means and why it happens:
What is Bad Debt?
- Definition: Bad debt is the portion of an outstanding loan that the lending protocol cannot recover, even after liquidating the collateral provided by the borrower.
- Key Indicator: It is recorded as a loss on the protocol’s balance sheet.
How Does It Happen?
- Insufficient Collateral:
- Borrowers typically need to over-collateralize their loans. For example, they might deposit $150 worth of assets to borrow $100.
- If the collateral’s value drops drastically (e.g., due to a market crash) before liquidation can occur, the protocol may end up with less than the loan amount.
- Liquidation Failures:
- Liquidation mechanisms might fail if market conditions are unfavorable (e.g., sudden illiquidity or extreme volatility).
- If there aren’t enough buyers for the collateral or the liquidation bots are delayed, bad debt can arise.
- Price Oracle Issues:
- Lending protocols rely on price oracles to assess the value of collateral.
- If the oracle feeds inaccurate or delayed prices, the protocol might fail to liquidate collateral in time.
- Exploitation or Hack:
- Vulnerabilities in the protocol can allow malicious actors to create loans that cannot be repaid.
- For example, in a flash loan attack, the attacker manipulates the collateral value temporarily.
Consequences of Bad Debt
- Protocol Insolvency:
- If bad debt accumulates, the protocol may struggle to maintain solvency, leading to loss of user confidence.
- Impact on Token Value:
- The protocol’s governance or utility token may lose value due to a lack of trust in its operations.
- User Losses:
- Users who supplied funds to the protocol (lenders) might face losses if the protocol uses their funds to cover bad debts.
How Do Protocols Manage Bad Debt?
- Insurance Funds:
- Many protocols maintain insurance reserves to cover losses from bad debt.
- Venus Finance for example has a Reserve Pool funded by protocol fees to manage such scenarios.
- Liquidation Mechanisms:
- Advanced algorithms and bots ensure timely liquidation of under-collateralized loans.
- Protocols continuously improve their liquidation infrastructure to minimize risks.
- Governance Actions:
- Protocols might use governance proposals to decide how to handle bad debts (e.g., minting new tokens or selling reserves).
Recent Examples
- Incident: In May 2021, during a sharp market downturn, Venus Finance experienced bad debt tied to a liquidation of a large borrower who held BNB as collateral.
- Impact: The protocol had to employ governance votes to manage and cover the losses, a common practice in DeFi protocols.
Aave Protocol (November 2022):
- Incident: A user borrowed a substantial amount of CRV tokens using USDC as collateral. Due to a flaw in the liquidation logic, a “toxic liquidation spiral” occurred, leading to bad debt for the protocol.
- Impact: The protocol incurred irretrievable debt exceeding $1.5 million, raising concerns about the feasibility of large lending platforms under decentralized governance.
Compound Finance (May 2022):
- Incident: A significant market downturn led to the rapid depreciation of collateral value, resulting in under-collateralized loans. The protocol’s liquidation mechanisms were unable to keep pace with the falling prices, leading to bad debt.
- Impact: Compound faced substantial bad debt, highlighting vulnerabilities in its liquidation process during periods of high volatility.
- Source: An Empirical Study of DeFi Liquidations: Incentives, Risks, and Instabilities
MakerDAO (March 2020):
- Incident: During the “Black Thursday” market crash, the value of collateral plummeted, and the Ethereum network became congested. This prevented timely liquidations, resulting in under-collateralized vaults and significant bad debt.
- Impact: MakerDAO accumulated approximately $6 million in bad debt, which was later covered by minting and auctioning new MKR tokens.
Cream Finance (August 2021):
- Incident: A flash loan attack exploited vulnerabilities in the protocol, allowing the attacker to borrow assets without sufficient collateral. This led to significant bad debt on the platform.
- Impact: Cream Finance suffered a loss of around $18 million due to the exploit, resulting in bad debt that affected its liquidity and user confidence.
These incidents underscore the challenges that DeFi lending protocols face in managing collateral and maintaining solvency, especially during periods of high market volatility or targeted attacks.