Debt Overhang

Debt overhang occurs when a protocol or entity has so much debt that any new investment primarily benefits existing creditors rather than shareholders or the protocol itself. This situation discourages necessary capital injections because the returns are captured by debt holders instead of being reinvested into growth or development.

In crypto, this often manifests when a decentralized lending protocol has high levels of undercollateralized debt, leading to a stagnation in innovation and development. It creates a perverse incentive structure where the protocol struggles to attract new liquidity, further exacerbating the financial distress.

Addressing debt overhang typically requires a restructuring of the debt, such as debt-for-equity swaps or haircuts, to realign incentives. Without such interventions, the protocol risks long-term insolvency and loss of user trust.