What Is the Concept of ‘Unbacked Liabilities’ in a DeFi Protocol?

Unbacked liabilities are the protocol's obligations to its users (e.g. deposits in a lending pool or stablecoins that should be pegged to $1) that are no longer fully covered by the protocol's assets (collateral or reserves). This happens after a major exploit or a market crash causes collateral impairment, leading to insolvency.

The protocol has a deficit that must be covered by a recapitalization mechanism.