Systemic Bad Debt

Systemic bad debt occurs when a protocol is unable to fully recover the value of a loan or derivative position from a borrower because the collateral value has dropped below the outstanding debt. This usually happens when market prices move faster than the liquidation engine can react, or when there is insufficient liquidity to sell the collateral.

When this debt remains on the protocol balance sheet, it represents a direct loss to lenders or the protocol's insurance fund. If the bad debt exceeds the available reserves, it can trigger a bank run or a total collapse of the protocol's value.

Preventing bad debt is the primary goal of rigorous risk management, including setting appropriate loan-to-value ratios. It is the ultimate indicator of a failure in a protocol's liquidation and risk-mitigation framework.