Undercollateralized Risk

Undercollateralized Risk occurs when the value of a borrower's collateral falls below the value of their debt, potentially leaving the protocol with bad debt. This usually happens during extreme market crashes where assets lose value faster than the liquidation mechanism can sell them.

Protocols attempt to mitigate this by setting conservative collateral ratios and utilizing efficient oracles. If bad debt accumulates, it can threaten the solvency of the entire lending pool.

Risk management models often include insurance funds or socialized loss mechanisms to handle these scenarios. It is a core concern for the long-term sustainability of decentralized finance.