# Bad debt

> Rating realised and unrealised losses per market, reserve and vault, normalised by size with a materiality gate.

Source: https://docs.1delta.io/risk/bad-debt/

---

Bad debt is the strongest *realised* signal available. Audits, curator AUM and
protocol age are proxies for expected safety; bad debt is money that was actually
lost or is currently unrecoverable. Where it exists, it dominates the rating.

Two flavours, both counted:

- **Unrealised** — debt currently backed by collateral worth less than the debt,
  which liquidation has not cleared. It signals a market that is broken *now*
  (stale oracle, illiquid collateral, uninterested liquidators). It may still be
  liquidated away.
- **Realised** — loss already socialised to suppliers. Permanent, and a track
  record for that market's parameters and curator.

---

## Normalise, then gate

Absolute USD is not a rating: $13,582 is catastrophic in a $495 market and noise
in a $1B one. The metric is the ratio

```
R = (badDebtUsd + realizedBadDebtUsd) / size
```

But raw `R` explodes on abandoned dust — a dead market everyone withdrew from,
leaving a tiny underwater remnant, produces ratios in the thousands of percent
while threatening nobody. Two guards:

1. **Materiality gate.** Rate as risky only if the market is either big enough to
   matter (size at least **$50,000**) or carries a large absolute loss (at least
   **$100,000**). Anything failing both is recorded as informational.
2. **Denominator floor.** Divide by `max(size, $50,000)` so a near-zero
   denominator cannot manufacture an infinite ratio.

---

## The rating table

| Condition | Score | Level |
| --- | --- | --- |
| No exposure and no warning | 1 | green |
| Failed the materiality gate (dust or abandoned) | 2 | green |
| `R` below 0.5% | 2 | green |
| `R` from 0.5% to 5% | 3 | yellow |
| `R` from 5% to 25% | 4 | red |
| `R` at or above 25% | 5 | red |

**Floors:**

- A provider's own `RED` bad-debt warning floors the score at 4. Their threshold
  is corroborating evidence and is trusted as a lower bound. `YELLOW` is not
  floored — most yellows are dust.
- Realised loss of at least $100,000 floors the score at 3, whatever the ratio.
  A permanent loss that happened is worth a mark even on a market that has since
  grown.

**No time decay.** Realised bad debt is cumulative on chain and is never decayed.
Normalisation ages it naturally: as a market recovers and supply grows, `R`
shrinks on its own, and a market that once took a loss and is now large and
healthy drifts back toward green without special-casing.

---

## Where the numbers come from

The concept is universal; the plumbing is not. Each protocol family exposes
losses differently, and the risk unit follows the protocol's own socialisation
model.

| Family | Risk unit | Source | Notes |
| --- | --- | --- | --- |
| **Morpho Blue** | market (collateral, loan) pair | Blue API `badDebt` and `realizedBadDebt`, plus market warnings | First-class. Losses are isolated to that market's suppliers and the vaults supplying it |
| **Aave V3.3+ forks** | reserve | on-chain `getReserveDeficit(asset)` against aToken supply | A deficit is debt burned at liquidation with no collateral left — realised, net of what the safety module already covered. Pre-3.3 pools have no first-class figure |
| **Gearbox V3** | pool, via credit accounts | walk `creditManagers -> creditAccounts -> calcDebtAndCollateral` | No deficit counter and no `lostAssets`: a pool counts every open loan as an asset, so an emptied credit account is only visible account by account. Bad debt is the summed shortfall of debt over collateral value |
| **Euler Earn / MetaMorpho V1.1** | vault | `lostAssets`, and the gap between claimed assets and what the vault can point at | See NAV integrity in [Vault risk](https://docs.1delta.io/risk/vaults/) |

The Gearbox case is worth stating plainly, because it is the shape of failure
that ordinary metrics miss entirely: a pool whose accounts have been emptied
keeps reporting its old TVL at a share price that keeps *rising*, because
interest accrues on debt nobody will ever repay.

---

## Vault propagation

A vault inherits its suppliers' losses. Each vault's proportional exposure is
its share of every market it supplies, summed:

```
R_vault = (vault badDebt + vault realizedBadDebt) / vaultTotalAssets
```

rated through the same table. This runs two ways for redundancy: the per-vault
rating computed by the bad-debt pipeline, and a live figure from the vault's
current allocation, with the worse of the two winning. The second path covers
every vault we score, not only the ones the provider's own bad-debt data reaches.

One refinement: a vault flagged red purely by a provider *warning* with no
measurable bad debt is capped at yellow and labelled differently. A red on this
dimension always means bad debt someone can point at.

---

## Composition

```
finalMarketScore = max(curatorMarketScore, badDebtScore)
finalLevel       = worst(curatorLevel, badDebtLevel)
```

Observed failure dominates predicted safety. The curator score, the bad-debt
score, the ratio and the warning level are all exposed alongside the result, so
a downgrade can always be traced to the number that caused it.