Curve's founder, Michael Egorov, has put forth a market-based solution to tackle approximately $700,000 in bad debt associated with LlamaLend, Curve's lending platform. In a governance post, Egorov outlined a plan that allows for a 'free-market based method of recovery with option-like payoff,' which would function as an investment opportunity for those looking to participate. The proposal invites, but does not require, the involvement of Curve DAO. The bad debt in question stems from LlamaLend's CRV-long market, where users can borrow Curve's crvUSD stablecoin against CRV, the protocol's governance token.

This trade essentially serves as a bet on CRV maintaining its value or increasing. However, if CRV's value drops too quickly, the collateral may not be sold rapidly enough to repay lenders in full, which is precisely what occurred following the October 10 crash.

Instead of seeking a bailout from Curve's DAO, Egorov suggests packaging the affected lender positions into a tokenized vault, allowing traders to buy and sell them through a dedicated Curve pool. The objective is to provide trapped lenders with an exit strategy while enabling outside buyers to determine the value of the distressed claims.

The bad debt resulted from the October 10 crash, which saw over $19 billion in leveraged liquidations within a matter of hours, marking the largest single-day deleveraging on record. Although Curve's crvUSD minting markets withstood the sell-off, LlamaLend was not entirely unscathed.

Prices plummeted while gas costs surged, leading to a scenario where certain liquidations could not occur in time. Lenders in the CRV-long market were left with deposits backed by approximately 70% of their stated value. The market is designed to mitigate this risk through an automated market maker built into the lending system, LLAMMA.

However, during the October 10 crash, the market moved too quickly, and arbitrage traders were unable to keep pace. As a result, some lender positions ended up in a vault token that cannot be redeemed at full value today. Egorov argued that the token still holds value since the loss is not open-ended.

The distressed positions already hold crvUSD converted from CRV, so further declines in CRV should not exacerbate the shortfall. If CRV rises above roughly $0.96, the conversion begins to reverse, and the positions start taking in CRV collateral again.

Full recovery would occur around $1.24. The proposed pool would utilize Curve's Stableswap design, with a 1% swap fee and liquidity centered around 71% solvency rather than full value. This means the pool would not treat the distressed token as if it were worth one dollar on the dollar; instead, it would price the token closer to the amount currently backing it.

For trapped depositors, the pool offers a choice: they can either wait for a CRV recovery or sell their vault tokens at a discount and move on. For buyers, the trade resembles a long-term bet on CRV, as they purchase a claim that is partly backed today and could increase in value if CRV recovers. This gives the token an 'interesting option-like property' on CRV's recovery, with some backing already in place.

The fair price and price floor of the token increase if CRV's price rises and do not decrease if CRV's price falls. Liquidity providers in the new pool would earn swap fees and any CRV incentives allocated by Curve's DAO. Admin fees would partly accrue in the distressed vault token itself.

Egorov has requested that the DAO retain these tokens rather than convert them, which would gradually transfer some of the bad debt onto Curve's balance sheet through trading activity. The timing of the proposal adds weight, as it comes on the heels of an attacker exploiting Kelp DAO's LayerZero bridge and releasing 116,500 unbacked rsETH worth approximately $292 million. The attacker then deposited the unbacked rsETH into Aave as collateral and borrowed real WETH against it. Aave now faces up to $230 million in bad debt, prompting an industry response in the form of a coordinated bailout through DeFi United, a recovery effort led by Aave service providers.

Egorov presents Curve's pool as an alternative model, where instead of relying on a bailout, Curve would create a market for distressed claims and allow buyers to determine the price. If this pilot study proves successful, it could be applied to similar challenging situations at Curve or other protocols.