Bad Debt Socialization

Bad Debt Socialization in Curvance

Bad debt socialization is a critical mechanism within the Curvance protocol, designed to maintain market stability and manage risk in cases where borrowers default on their loans, leaving a shortfall in collateral. For example, if a borrower owes $500 but has collateral worth only $300, a $200 shortfall arises.

Bad debt socialization addresses isolated and cross-margin scenarios, providing a nuanced solution that differentiates it from other protocols.

How Bad Debt Socialization Works

When an undercollateralized position is liquidated, and a shortfall remains (e.g., $200), the deficit is socialized across the entire lender market to protect market health. This process involves an adjustment to the exchange rate of each lender’s token, allowing the shortfall to be absorbed proportionally by all lenders:

• Proportional Distribution: The shortfall is distributed across all lenders within the affected market. Each lender’s token value for redemption is slightly reduced to cover the debt, ensuring that the impact on each lender is proportional to their market participation.

• Exchange Rate Adjustment: Adjusting the exchange rate systematically distributes the deficit, preventing any single lender from bearing an excessive share of the loss. This method stabilizes the market and keeps it operational, even in significant default events.

Rationale and Lender Risk

Bad debt socialization aligns with the inherent risks lenders assume when participating in the protocol. Since lenders are exposed to borrower defaults, sharing the impact of bad debt across all participants is an equitable solution. This approach decreases risk to lenders and strengthens the protocol’s resilience by preventing bad debt accumulation that could destabilize the market.