Liquidation is meant to close a failing loan before the collateral is worth less than the debt. When prices move faster than liquidators can act, the gap remains as bad debt.
Liquidation depends on someone choosing to act
A lending protocol does not sell collateral itself. It publishes the conditions under which anyone may repay part of a borrower's debt and claim collateral at a discount.
That discount is the liquidator's incentive, and it has to cover gas costs, slippage on the sale and the risk that prices move during execution. If it does not, nobody bids.
So liquidation is a market response rather than an automatic event. Positions can sit underwater for as long as acting on them is unprofitable.
How the shortfall is created
Collateral requirements are set with a buffer, so a healthy loan is overcollateralized. The buffer is sized for expected volatility rather than for the worst case.
A sharp price move can consume that buffer between blocks. By the time a liquidator transacts, the collateral may already be worth less than the outstanding borrow.
The liquidator then has no reason to participate, because repaying the debt would cost more than the collateral returns. The position stops being liquidatable in any economic sense.
Where the loss actually lands
The borrower has already received the borrowed assets and has no obligation beyond the collateral. There is no recourse to anything outside the protocol.
The lost value therefore comes out of the pool that funded the loan. Depositors in that market hold claims on assets that are partly backed by an uncollectible balance.
Whether they notice depends on the design. Some protocols write the loss down immediately, while others leave it accruing interest on paper until governance recognizes it.
Why recognition is a governance decision
Bad debt that is never written down keeps accruing nominal interest, which inflates the pool's stated assets. The exchange rate for depositors then overstates what can actually be withdrawn.
That creates a queue problem. Early withdrawers exit at the overstated rate, and whoever remains absorbs a larger share of the shortfall.
Protocols mitigate this with reserve funds accumulated from interest, insurance modules or backstop pools. These are pre-funded buffers designed to absorb a shortfall before depositors do.
Why isolated markets change the exposure
In a shared pool, collateral of many types backs one set of lenders, so a failure in one asset reaches everyone in that pool.
Isolated market designs pair a single collateral asset with a single borrowable asset. Bad debt is then contained within that pair rather than spreading across the protocol.
The tradeoff is fragmentation. Isolated markets hold thinner liquidity, which makes liquidation harder to execute and can make the original shortfall more likely to occur.