Curve's founder, Michael Egorov, has put forth a market-based solution to address approximately $700,000 in bad debt associated with LlamaLend, Curve's lending platform. In a governance post, Egorov proposed a 'free-market based method of recovery with option-like payoff' that would function as an investment opportunity for those wishing to participate in the recovery efforts, with Curve DAO being 'invited but not required'. The bad debt is a result of losses in LlamaLend's CRV-long market, which allows users to borrow Curve's crvUSD stablecoin against CRV, the protocol's governance token.

This trade operates as a bet that CRV will maintain its value or increase. However, if CRV falls too rapidly, the collateral may not be sold quickly enough to repay lenders in full, which is precisely what occurred following the October 10 crash. Rather than requesting Curve's DAO to cover the shortfall, Egorov suggests packaging the affected lender positions into a tokenized vault and 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. LlamaLend's bad debt resulted from the crash, which saw over $19 billion in leveraged liquidations within hours, the largest single-day deleveraging on record.

Curve's crvUSD minting markets withstood the sell-off, but LlamaLend did not fully escape the damage. Prices fell rapidly while gas costs rose, leading to a scenario where some 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.

Instead of selling a borrower's collateral all at once when prices fall, LLAMMA converts the collateral in steps as the market moves. Egorov argued that the providers of borrowable liquidity in this market were exposed to losses during liquidation protection and, as a result, cannot withdraw their positions, which are currently around 70% backed.

However, during the October 10 crash, the market moved too quickly. Arbitrage traders, who help maintain the system's balance by buying and selling across price gaps, could not keep up.

Some lender positions ended up in a vault token that cannot be redeemed at full value today. Egorov contended that the token still holds value because the loss is not open-ended.

The distressed positions already hold crvUSD that was converted from CRV, so further CRV declines should not deepen the shortfall. If CRV rises above approximately $0.96, the conversion starts to reverse, and the positions begin 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 become worth more if CRV recovers.

This gives the token an 'interesting option-like property' on CRV's recovery, but with some backing already in place. The fair price and price floor of the token increase if CRV's price goes up and do not decrease if CRV's price goes down. Liquidity providers in the new pool would earn swap fees and any CRV incentives that Curve's DAO chooses to allocate.

Admin fees would partly accrue in the distressed vault token itself. Egorov has asked the DAO to keep those tokens rather than convert them, which would slowly move some of the bad debt onto Curve's balance sheet through trading activity. The timing of the proposal adds weight, as it comes after an attacker exploited Kelp DAO's LayerZero bridge and released 116,500 unbacked rsETH worth about $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 is presenting Curve's pool as a different model, one that builds a market for distressed claims and lets buyers decide the price, rather than passing the hat across the industry.

If this proves to be a successful pilot study, it could be applied in similar difficult situations at Curve or other protocols.