In the simplest terms, bad debt in alending and borrowing protocol occurs when the protocol doesn't have enoughfunds to pay back all its lenders. It's like a ticking time bomb; it may notcause immediate damage, but the situation could escalate if all lenders decideto withdraw their funds simultaneously. Most renowned lending protocols havesome level of bad debt for certain tokens. A noteworthy mention here is @Risk_DAO , a project that analyzes bad debtacross various protocols. For a detailed breakdown of which protocol is facinghow much bad debt, check out their insightful analysis here:
https://bad-debt.riskdao.org
TheInvestor's Dilemma: To Stay or Not to Stay
What does this mean for you as an investor?It's pretty straightforward - caution is key. It's generally advisable to steerclear of protocols with substantial bad debt. If you're invested in a marketplagued by bad debt, consider withdrawing your deposit to avoid potentiallosses. Remember, being proactive is better than being reactive in thisvolatile world.
How does bad debt come about? Assuming aprotocol's smart contract is rock-solid, there's typically one main culprit:delayed liquidations. Let's illustrate this with a scenario:
1. Bob deposits 2200 USDT and borrows 0.8ETH when 1 ETH equals 2200 USDT.
2. The ETH price increases, making Bob'sposition ripe for liquidation. However, no one liquidates Bob's position forwhatever reason.
3. As ETH's value surges further, Bob'sborrowed 0.8 ETH is now worth more than his 2200 USDT deposit. Bob loses theincentive to repay the ETH, leading to bad debt for the protocol.
Even if Bob's 2200 USDT is liquidated andconverted back to ETH, the protocol ends up with less than 0.8 ETH.
Lenders of ETH are effectively at a loss,particularly the last ones trying to withdraw.
Prevention is better than cure, especiallyin DeFi. Here are a couple of strategies:
Efficient and Fast Liquidations: Protocolsneed mechanisms for quick liquidation, possibly even as a privileged functionin emergency situations.
Choosing the Right Collateral: Avoid highlyvolatile tokens as collateral. For such tokens, it's crucial to use reasonableLoan-to-Value (LTV) ratios to mitigate risks.
About @avi_eisen and @mangomarkets :
A prominent example of bad debt spiralingout of control is the Avraham Eisen case, where he artificially inflated thevalue of the Mango token. He used this inflated collateral to borrow funds,creating a precarious situation for the protocol and its users.
