What Is “Under-Collateralization” and What Is Its Consequence?

Under-collateralization occurs when the value of the collateral backing a debt or derivative position falls below the value of the liability. In a DeFi protocol, this means the system has "bad debt" that cannot be fully covered by the liquidated assets.

The consequence is a threat to the protocol's solvency, often requiring a bailout from a governance fund or a recapitalization event.