Bad Debt Risk

Definition

Bad debt emerges when a borrower's collateral cannot be liquidated for enough value to fully repay the outstanding debt. The shortfall between liquidation proceeds (minus execution costs) and outstanding obligations becomes the bad debt burden.

Triggers

• Swift collateral value declines exceeding liquidation speed

• Market depth deterioration causing substantial slippage during asset sales

• Liquidations becoming economically unviable due to fees, MEV, or thin liquidity

• Network disruptions preventing timely liquidation or inflating transaction costs

Loss Distribution

Bad debt typically affects lenders through socialized losses across liquidity providers rather than concentrating on single parties. This reduces total available assets or diminishes realized yields.

Mitigations

Fira employs liquidation thresholds and exposure caps using conservative, data-informed methodologies based on historical price volatility and execution data.

Limitations

• Extreme price gaps can bypass protections

• Sudden liquidity disappearance

• Oracle failures

• Smart contract issues

Key Risk

Lenders face credit-like risk comparable to borrower defaults, with losses most likely during stress periods when market volatility peaks and liquidity contracts simultaneously.