Pool Insolvency Risk

Risk Description

Bad debt occurs when a loan can't be fully repaid by its collateral, causing a loss for the lenders in the isolated market. While over-collateralized loans are designed to prevent this through liquidation, where third parties repay the debt and seize the collateral for a profit, this mechanism may not always work.

Bad debt can happen even in over-collateralized markets due to a few key reasons amongst others:

• Extreme market volatility: The collateral's price drops so fast that by the time a liquidation is processed, its value is already less than the debt.

• Network congestion: During market crashes, the blockchain can become slow and expensive to use, preventing liquidators from executing their transactions in time or making it unprofitable for them to do so.

• Illiquid collateral: If the collateral is a less popular token, a liquidator's attempt to sell it to cover the debt can cause its price to crash, leaving the loan under-collateralized.

When these situations occur, the protocol is left with an unrecoverable loan, creating bad debt that must be shared through "risk socialization".

Risk Control

The platform incorporates a socialization of losses mechanism to mitigate the pool insolvency risks associated with LPing to higher risk tokens. While some bad debt may occur, it is managed by distributing any incurred losses pro-rata across all liquidity providers (LPs). This approach prevents catastrophic losses for any single LP and ensures that individual risk remains minimal. Over time, the high aggregate yields are designed to significantly outweigh these distributed losses, maintaining overall profitability for participants.