What is bad debt risk?
Bad debt arises when a borrower's collateral is liquidated but the proceeds aren't enough to fully repay the outstanding loan. The gap — called bad debt — becomes a loss that the protocol has to absorb. In practice, that loss falls on lenders.
What can happen
Several scenarios can create bad debt:
Rapid price drop — Collateral loses value so quickly that liquidators can't act before the position is already underwater. The faster the drop, the worse the potential shortfall.
Market depth deterioration — Liquidators need to sell the collateral asset to recover funds. If there isn't enough market depth, they take severe slippage, and the proceeds don't cover the debt.
Uneconomical liquidations — If liquidation fees, gas costs, and MEV conditions make a liquidation unprofitable for external liquidators, the position sits unliquidated — growing the potential shortfall.
Network congestion — During extreme market events, Ethereum gas prices spike. Transactions can get stuck or priced out, delaying liquidations at the worst possible moment.
These conditions often occur together: a market crash causes prices to drop fast, liquidity disappears, gas spikes, and liquidations get delayed simultaneously.
How losses are distributed
Bad debt isn't charged to a single person. It's socialized across all lenders in the affected market — reducing the total assets available for withdrawal, which means each lender's share of the pool is worth slightly less. Lenders bear credit-like risk comparable to a borrower default.
How Fira mitigates this
Conservative LLTV thresholds: Liquidation is triggered before positions reach a zero-equity state, leaving a buffer for execution
Collateral exposure caps: Markets have caps on how much of any single collateral can be used, limiting concentration risk
Conservative collateral selection: Only assets with demonstrated liquidity depth and price stability are listed
Methodology: Parameters are set using historical price volatility and on-chain execution data
Limitations
Even conservative parameters cannot protect against extreme price gaps (e.g. a collateral asset losing 50% in minutes), sudden and total liquidity disappearance, or a simultaneous failure of multiple risk factors. These tail events are rare but have occurred in DeFi.
What you can do
Understand that as a lender, you are exposed to the credit quality of the borrowers in your market — not just the interest rate
Diversify across markets to avoid concentration in any single collateral type
Consider the collateral composition of markets before depositing; higher-risk collateral means higher bad debt exposure
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