Dealing with Bad Debt in DeFi

In this article, we’ll address several issues surrounding bad debt. We’ll look at how bad debt was incurred, how Hubble handled the situation, and how Hubble’s model ensures that USDH remains solvent without affecting the entire community.

Key Takeaways:

  • There are multiple ways a protocol can take on bad debt.
  • Hubble's smart contracts are designed to handle underwater loans.
  • Actively managing risk includes finding new solutions for difficult situations.

Hubble Protocol recently handled some bad debt. Early actions from the community helped derisk positions, though, and the least toxic bad debt was socialized through redistribution.

During redistribution, every user with an open loan received some of the outstanding USDH debt as well as some of the seized collateral from underwater loans. Since the loans were underwater, users received slightly more debt than collateral.

This article will address several issues surrounding bad debt. It will look at how bad debt was incurred, how the Hubble community handled the situation, and how Hubble’s smart contracts ensure that USDH remains solvent.

How Can Over-Collateralized Loans Incur Bad Debt?

The extreme volatility of the crypto market is one of the reasons why DeFi loans must be over-collateralized by a safe margin. Over-collateralization provides breathing room for a creditor to liquidate bad loans before it has to eat bad debt.

For example, if a loan has a liquidation threshold of 80% loan-to-value (LTV), liquidated assets can drop another 20% before a creditor is faced with bad debt. Crypto prices can swing so erratically that it’s possible for an asset to drop by 50% in an hour, so the breathing room provided by over-collateralization is an important feature of DeFi.

Hubble requires users to over-collateralize their borrowing, but the protocol ran into some bad debt for several reasons. In crypto, anything can happen, and here are just a few ways assets can lose their value and affect the collateralization of a loan.

Instant Insolvency

Collateral (soBTC) became instantly toxic when FTX declared bankruptcy. Wrapped BTC has value because it can be unwrapped for BTC—but FTX was holding this BTC. When FTX officially went under, the value of soBTC also fell off the map.

Imagine an alternative situation where FTX didn’t file for bankruptcy and users could still unwrap soBTC for BTC. Then, the exchange is hacked and drained of all assets. This would also mean the BTC backing soBTC is no longer available.

Low Liquidity

When Hubble first launched, SRM was a highly liquid asset on Solana that could be traded in large amounts easily. It was the utility token of an innovative on-chain order book, Serum, that had billions of dollars in TVL and was backed by some of the biggest names in crypto.

However, the liquidity for SRM disappeared recently, most likely due to Alameda and FTX. Thin liquidity on-chain can cause extreme price slippage, so swapping 20 million SRM for other tokens would result in a swap worth 10% of SRM’s reported market value.

Asset De-Pegging

Assets like stablecoins and liquid staking tokens have prices that are pegged to another asset, like the dollar or SOL. During periods of extreme volatility, these assets can lose their peg, which means they have a different market value than they should.

During the recent crash, several liquid staking tokens had a market value that was much lower than SOL. Oracle price feeds did not reflect this change immediately, and when the correct prices for these assets were updated, their value fell by around half, instantly.

Bad Oracle Feeds

Oracles help smart contracts know how much an asset is worth. Strong and accurate oracles often query the price of an asset from multiple sources like exchanges and other sites where an API displays a current price.

If exchanges are reporting different prices due to extreme volatility, then oracles have a difficult time updating. When this happens, Hubble's smart contracts reject any price feeds that are not deemed accurate by the protocol’s rigorous standards for accepting a true price.

A loan can appear to have a healthy LTV due to a bad oracle, so Hubble’s liquidation mechanism won’t trigger. If the oracle updates a true lower price that puts a loan over its maximum LTV, it’s possible the loan could be liquidated with bad debt.

Failed Liquidations

Every blockchain network experiences network degradation during high periods of volatility. When many users are trying to push through thousands of transactions at once, then a lot of transactions begin failing.

If transactions are failing on a network, then it becomes increasingly difficult to finalize the transaction that triggers a liquidation. There will be multiple attempts to liquidate a loan with an unhealthy LTV, but there’s a chance that the liquidation transaction finally goes through when the assets collateralizing the loan have fallen so much, the loan incurs bad debt.

How Does Hubble Handle Bad Debt?

Hubble Protocol was originally launched with three possible mechanisms for handling bad debt: the Stability Vault (Stability Pool), redistribution, and redemptions. Of these three, Hubble has discarded redemptions, deeming them unfair.

The Stability Vault allows users to deposit USDH in order to guarantee loans through liquidation. When a debt is liquidated, USDH in the Stability Vault is burned to match the missing debt, and the seized collateral is distributed to users who provided the USDH.

If the Stability Vault is emptied, then debts are liquidated through redistribution, and every open loan receives some USDH debt and seized collateral in proportion to the size of its outstanding debt. However, if the Stability Vault has USDH and an underwater loan must be liquidated, then redistribution kicks in and bypasses the Stability Vault.

This is not preferential treatment to Stability Vault depositors, since all users end up receiving some debt and some collateral. Unfortunately, when debts are socialized due to clearing bad debts, everyone also receives less collateral value than USDH debt.

Facing invalid oracle prices, the protocol realized that changing to an oracle that better reflected the value of tokens as they traded on-chain would lead to a cascade of liquidations. In response, liquidations were paused while oracles were updated, and users were given a chance to derisk their positions in soBTC and SRM.

Then, before reactivating liquidations, these toxic assets were removed through redemptions, ensuring users would not absorb bad debt from soBTC and SRM.

Bad Debt Means Making Difficult Choices

Bad debt is something that cannot be predicted beforehand, and it usually catches everyone affected by it off guard—who could have seen the FTX meltdown on the horizon? It should be noted that dealing with bad debt is a difficult surprise for everyone–even for exemplars of risk management like MakerDAO.

In a recent vote on how to clear bad debt from MakerDAO’s books, over 50% of the voters voted “Abstain” against “Yes” or “No” when asked, “Shall MakerDAO clear the vaults’ bad debt?” Another 50% abstained from voting on a method to clear debt, rendering the vote useless with no action taken.

Hubble Protocol was designed to clear bad debt through redistribution, an action automatically triggered by the protocol's smart contracts.

However, there can be other options for clearing bad debt that does not require socialization, and those avenues will be thoroughly explored to make Hubble as anti-fragile as possible.

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