Bad Debt Write-off Mechanisms

Bad Debt Write-off Mechanisms are the processes a protocol uses to handle debt that cannot be recovered through liquidation. This happens when the value of the collateral drops so rapidly that it is impossible to sell it for enough to cover the outstanding debt.

To protect the protocol's overall health, the system must absorb this loss, often by using a reserve fund or by diluting the protocol's governance token. These mechanisms are a last resort and are designed to prevent the failure of the entire system.

Having a clear and effective write-off process is essential for maintaining user trust, as it defines how the protocol survives extreme market events. These mechanisms highlight the inherent risks of decentralized lending and the importance of over-collateralization.