Curve's founder, Michael Egorov, has introduced a market-based approach to resolve approximately $700,000 in bad debt associated with LlamaLend, the lending platform of Curve. 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 willing to participate.

This proposal invites, but does not require, the involvement of Curve DAO. The bad debt in question is tied to LlamaLend's CRV-long market, where users can borrow the crvUSD stablecoin against CRV, the governance token of the protocol.

This setup essentially acts as a wager that CRV will maintain or increase its value. However, if CRV's value drops too rapidly, the collateral may not be sold quickly enough to fully repay lenders. This scenario played out following the October 10 crash, triggered by an announcement from President Donald Trump regarding tariffs on Chinese goods.

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 aim is to provide an exit for trapped lenders while enabling outside buyers to determine the value of the distressed claims.

The bad debt stems 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 spared. Prices plummeted while gas costs soared, leading to a situation where some liquidations could not occur in a timely manner.

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, LLAMMA, integrated into the lending system.

LLAMMA converts collateral in steps as the market moves, rather than selling it all at once when prices fall. However, during the October 10 crash, the market moved too swiftly. Arbitrage traders, who help maintain the system's balance by buying and selling across price gaps, were unable to keep up.

As a result, some lender positions ended up in a vault token that cannot be redeemed at full value today. Egorov argued that this token still holds value because 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 approximately $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, featuring 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 its current backing.

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' regarding CRV's recovery, 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 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 converting them, which would gradually transfer some of the bad debt onto Curve's balance sheet through trading activity.

The timing of this proposal adds weight, given the recent exploit of Kelp DAO's LayerZero bridge, which resulted in the release of 116,500 unbacked rsETH worth about $292 million. An attacker then used this unbacked rsETH as collateral to borrow real WETH on Aave, leaving Aave with up to $230 million in bad debt.

The industry's response has been a coordinated bailout effort, DeFi United, which has raised approximately $160 million of the roughly $200 million needed so far. Egorov presents Curve's pool as an alternative model, where instead of relying on an industry-wide bailout, a market for distressed claims would be created, allowing buyers to determine the price. If this approach proves successful, it could be applied to similar challenging situations at Curve or other protocols.