When liquidators are unwilling to take over low-liquidity collateral, bad debt does not start at the moment "no one steps in." It starts the very moment liquidation is no longer profitable—or even results in a loss. The origin of bad debt lies before the liquidation happens, not after.
To understand this clearly, you first need to see the dividing lines in liquidation.
In the Morpho lending protocol, a borrower's health during the liquidation process is strictly split into three zones:
LTV < LLTV (Healthy) — The borrower is solvent and cannot be liquidated.
LLTV < LTV ≤ 1/LIF (Liquidatable Zone) — Liquidators can repay part or all of the debt and take a proportional amount of collateral. The liquidator can make a profit, and bad debt has not yet formed.
1/LIF < LTV (Bad Debt Zone) — Even if the liquidator takes all the collateral, it only covers part of the debt. No one is willing to repay the remaining debt. That leftover debt is bad debt.
Bad debt is not caused by "collateral being unsellable"—it is caused by the collateral value falling below the debt value.
When the collateral is a low-liquidity asset, the problem gets even worse. A liquidator essentially profits by "buying collateral at a discount"—they repay your debt, take your collateral, and then sell it on the market to get cash back. But if that collateral cannot be sold on a DEX at all, or if the slippage from selling it eats up all the profit, liquidators simply won't do the trade.
Risk Warning: Liquidity issues can also create "zombie debt." When a borrower's debt is too small, even if a liquidator takes all the collateral, it is still not profitable after deducting gas fees. This position will remain in an "insolvent but unliquidated" state indefinitely, sitting on the books and eating away at the protocol's health.
Step 1: Calculate Whether Liquidation Is Still Profitable
To determine whether an unhealthy position is worth taking over, a liquidator checks if the liquidation incentive covers gas costs. The collateral value the liquidator receives = debt repaid × Liquidation Incentive Factor (LIF). If debt repaid × LIF - gas fee ≤ 0, no liquidator will come. Completion standard: You confirm whether the current unhealthy position has already entered the "unprofitable" range.
Step 2: Determine Whether Liquidation Requires an Auction
Case A: Atomic Liquidation The liquidator completes both "repaying your debt" and "taking the collateral" in a single transaction. The profit or loss is certain; the liquidator only needs to judge the relationship between the collateral's market value and the debt amount.
Case B: Auction Liquidation The liquidator first participates in an auction and, after receiving the collateral, needs to find their own way to sell it. If the collateral has poor liquidity, by the time the auction ends and they are ready to sell, the price may have already dropped below their cost. In MakerDAO's history, liquidators suffered losses in 641 liquidations due to collateral price changes during the auction process.
Step 3: Has the Bad Debt Already Been "Socialized"?
Once low-liquidity collateral falls into the bad debt zone, the ultimate loss will not be borne by the borrower (who is already unable to repay), but by all depositors. Morpho Vault's mechanism proportionally distributes the bad debt among all suppliers in that market—the share price will drop, and the net asset value behind every one of your shares will shrink.
Why Liquidations Fail
Many people mistakenly believe that "as long as the collateral is still there, the protocol can recover funds through liquidation," but they overlook the core prerequisite for liquidation—the liquidator must be able to profit. If this condition is not met, liquidation will not happen, and bad debt will keep accumulating. Especially during violent market swings, drastic changes in the ETH/BTC price ratio can trigger a concentrated surge in liquidation demand, and the difficulty of liquidating low-liquidity collateral only makes the problem worse.
Next Steps
If you discover that the vault you invested in uses low-liquidity collateral at its base, check that collateral's liquidity depth on major DEXs (you can use TradingView or DexScreener). If the 24-hour trading volume is less than 10 times the debt size, it means it is very difficult for liquidators to exit smoothly. Once the price moves, the bad debt will be borne by you. Consider lowering your allocation to that vault, or prioritize vaults that only use high-liquidity collateral.
