A bad debt event occurs when a borrower defaults on a loan, and the collateral held against that loan is insufficient to cover the outstanding amount. In decentralized finance, this typically arises when the value of deposited collateral falls below a liquidation threshold, yet the liquidation process fails to fully repay the debt. Such an occurrence leaves the lending protocol with an unrecoverable deficit. This situation poses a direct financial risk to the protocol’s solvency and its liquidity providers.
Context
Discussions around bad debt events in DeFi often center on the robustness of liquidation mechanisms and oracle reliability during extreme market volatility. Protocols continuously refine their risk parameters and collateralization ratios to mitigate these exposures. The potential for cascading liquidations during market downturns remains a critical concern for systemic stability.
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