Default Risk

Default risk refers to the possibility that a borrower will be unable to make the required payments on their debt obligations. In the context of decentralized finance, this is mitigated through over-collateralization, where the value of the locked assets exceeds the value of the loan.

If the borrower defaults, the protocol can liquidate the collateral to satisfy the debt. This automated approach replaces the need for credit scores or legal recourse found in traditional finance.

However, default risk still exists if the market moves too quickly for the liquidation engine to respond, potentially leaving the protocol with bad debt. Managing default risk is a constant balancing act between allowing high leverage and maintaining system-wide security.

It is a fundamental consideration for all lending and derivative protocols.