What is bad debt in DeFi?

Bad debt in DeFi is the portion of a loan that cannot be recovered from its available collateral. Falling asset prices, insufficient sale liquidity, delayed liquidations or contract incidents can create a shortfall.

Health factor tracks liquidation eligibility. A reading below 1 does not automatically mean all collateral is worth less than the debt. Read the protocol’s liquidation rules separately from the amount that can actually be collected.

Example

Suppose a position owes $900. After costs and incentives, all its collateral provides $870 for repayment. The remaining shortfall is $900 − $870 = $30. If collateral has already been sold, a later token-price recovery does not bring the old assets back. These figures illustrate the arithmetic, not a measured protocol loss.

Who covers the gap?

That depends on protocol rules. Available reserves, an insurance-like mechanism or a governance decision may contribute; full coverage is not guaranteed. A recorded deficit and the loss ultimately passed to a user need not be identical. A collateral token departing from its target value is described as a depeg.

Our stablecoin collateral stress analysis explains why a loan shortfall can survive a price recovery, using the March 2023 USDC case and separately labelled hypothetical calculations.