Michael Egorov, the founder of Curve, has introduced a market-based approach to resolve approximately $700,000 in bad debt associated with LlamaLend, Curve's lending platform. In a governance post, Egorov outlined a 'free-market based method of recovery with option-like payoff,' which would function as an investment opportunity for those who want to participate in the recovery efforts.

Curve DAO has been invited to participate but is not required to do so. The bad debt is currently situated in LlamaLend's CRV-long market, where users can 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 what occurred after the October 10 crash.

Instead of requesting Curve's DAO to cover the shortfall, Egorov proposes 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.

The bad debt resulted from the October 10 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 about 70% of their stated value.

The market is designed to reduce 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 cannot withdraw their positions, which are currently around 70% backed. However, during the October 10 crash, the market moved too rapidly.

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 argued that the token still has 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 roughly $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. 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 appears to be a long-term bet on CRV.

They buy 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.

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 proposal comes at a time when the DeFi industry is dealing with the aftermath of an attacker exploiting Kelp DAO's LayerZero bridge, resulting in Aave facing up to $230 million in bad debt. The industry response has been 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. If this proves to be a successful pilot study, it could be applied in similar difficult situations at Curve or other protocols.