Bad debt: what happens when liquidations do not keep up

Overcollateralization works while the collateral can be sold for more than the debt. When it cannot - bad debt is born: a hole that always finds an owner.

How the hole appears

• A gap faster than the liquidation: a crash of dozens of percent in minutes - the collateral is already worth less than the debt, liquidating is pointless.
• Thin collateral: the protocol accepted an illiquid token; selling it during a liquidation crashes the price by itself - the classic of the Mango attack and the motive of the 2023 CRV-position case.
• Oracle manipulation: pump the collateral's price on a thin market → borrow against the painted valuation → vanish. Exploiters' favorite vector.

Who pays

In order: the protocol's insurance module/treasury (if any), then the pool depositors who will not get their assets back, or the governance token holders via emission to cover the hole. DeFi's history has precedents of every variant.

What a depositor should check

The list of accepted collateral (thin-liquidity exotics = your risk), the caps per asset, the insurance fund's size against TVL, the protocol's bad-debt history. Risk dashboards are public - at mature protocols bad debt is visible in real time. The deposit rate is the price at which you insure these scenarios.