Bad Debt Mitigation

Bad Debt Mitigation refers to the strategies and mechanisms employed by a protocol to prevent or recover losses when a borrower's collateral value becomes insufficient to cover their debt. This occurs when market prices drop so rapidly that the liquidation engine cannot sell the collateral at a price high enough to cover the outstanding liability.

Protocols mitigate this risk through insurance funds, socialized loss models, or surplus auctions. An insurance fund is a reserve of capital built from liquidation fees that is used to cover the shortfall.

If the insurance fund is insufficient, the protocol might reduce the payouts to other lenders or issue new tokens to recapitalize. Effective mitigation is essential for maintaining trust and stability in lending markets.

It involves balancing the need for safety with the desire to minimize the burden on healthy participants.