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.
Glossar
DeFi Protocol Core
Architecture ⎊ DeFi Protocol Core represents the foundational codebase and smart contract infrastructure enabling decentralized financial applications, functioning as the deterministic engine for on-chain operations.
DeFi Protocol Fees
Mechanism ⎊ DeFi Protocol Fees are transactional costs levied by decentralized applications, or protocols, for the execution of various on-chain functions, including swaps, lending, borrowing, and derivative contract settlement.
Validator Duties and Liabilities
Duty ⎊ Validator duties encompass the mandatory, continuous technical responsibilities required of a node operator to secure a Proof-of-Stake blockchain and earn staking rewards.
Debt Overhang
Condition ⎊ Debt overhang describes a severe financial condition where a protocol's or entity's outstanding liabilities, often stemming from under-collateralized loans or derivative losses, significantly exceed the current market value of its assets.
On Balance Sheet Liabilities
Obligation ⎊ On Balance Sheet Liabilities represent the financial obligations a firm is legally required to report on its statement of financial position, including debts, payables, and, critically, the custodial obligation for client assets under certain accounting interpretations.
Wrapped Token Liabilities
Liability ⎊ Wrapped Token Liabilities denote the financial obligation of a centralized or decentralized custodian to redeem a wrapped digital asset for its underlying native cryptocurrency at a one-to-one ratio.
Crypto Asset Liabilities
Obligation ⎊ Crypto asset liabilities represent financial obligations denominated in digital assets, such as the outstanding tokens issued by a stablecoin provider or the short positions held by a derivatives exchange.
Smart Contract Risk
Vulnerability ⎊ Smart contract risk, within cryptocurrency and derivatives, stems fundamentally from inherent code flaws and systemic dependencies.
DeFi Protocol Integrity
Resilience ⎊ DeFi Protocol Integrity, within the context of cryptocurrency and derivatives, concerns the capacity of a system to maintain intended functionality despite adverse conditions, encompassing market volatility, code exploits, and systemic risk.
Hidden Liabilities
Exposure ⎊ Hidden Liabilities represent undisclosed or inadequately provisioned financial obligations that do not appear clearly on a firm's balance sheet or are obscured within complex off-chain arrangements.