Crypto glossary
Bad debt
Bad debt in DeFi is debt left uncovered when collateral falls below the loan value before liquidation, leaving a loss someone in the protocol must absorb.
A lending protocol stays solvent as long as every loan is backed by collateral worth more than the debt. If prices crash too fast, an oracle fails or the collateral is too illiquid to sell, liquidators may not step in in time. Once collateral is worth less than what was borrowed, nobody has an incentive to repay the loan, and the shortfall becomes bad debt on the protocol's books.
Bad debt is one of the clearest signs of a risk-management failure. It has followed oracle manipulation attacks on thinly traded tokens, depegs of collateral assets and sudden market crashes. Analysts track it on risk dashboards because it shows whether a protocol's parameters were too generous.
Who pays depends on design. Some protocols cover losses from a reserve or insurance fund, others mint and sell governance tokens, and in isolated markets the loss is spread among depositors of that specific vault. If none of these backstops is enough, lenders may be unable to withdraw their full balance.
Example
An attacker inflates the oracle price of a small token, borrows stablecoins against it and leaves; when the price snaps back, the protocol is left with several million dollars of bad debt that its reserve fund must cover.