Bad Debt Socialization

In the Curvance protocol, bad debt socialization is a critical mechanism for maintaining healthy markets and mitigating risks when borrowers default, potentially exposing all participants to bad debt situations. This occurs, for example, when a borrower owes $500, but their collateral is only worth $300, resulting in a $200 shortfall.

Curvance has developed a sophisticated approach to managing bad debt, uniquely addressing both isolated-margin and cross-margin scenarios. This sets Curvance apart from other protocols based on its unique approach to financial complexities.

When an undercollateralized position is liquidated, and a gap of $200 exists between the repayment amount and the collateral value, the remaining $200 shortfall is then socialized across the entire lender market. This is where the adjustment of the exchange rate of each lender's token plays a critical role.

The shortfall is proportionally distributed across all lenders by systematically adjusting their token exchange rates. This means that each lender's token value for redemption is slightly decreased to cover the collective deficit.

The exchange rate adjustment is carefully calculated to ensure that the impact on each lender is proportional to their participation in the isolated market. This prevents any single lender from bearing a disproportionate share of the loss. Adjusting exchange rates to socialize the bad debt makes the market stable and functional, even in the face of significant defaults. This mechanism prevents the accumulation of bad debt that could destabilize the market and cause lenders to suffer greater losses.

This comprehensive approach's rationale lies in recognizing the lenders' role within the Curvance protocol. As such, they inherently assume the risk of borrower defaults. Therefore, in instances of default, it is equitable for lenders to share the impact of the resulting bad debt. This method aligns with the structure of the lending process within Curvance, emphasizing the risk exposure of lenders and the collective bearing of any losses incurred.

Curvance's model of bad debt socialization, aided by strategic exchange rate adjustments, effectively minimizes systemic risks and maintains the integrity of the protocol. As an overall goal, the Curvance DAO works towards an equitable distribution of debt without being a direct loan issuer, adhering to essential legal and financial compliance standards.