# Bad Debt Risk

## Context

In certain situations, the collateral's value may fall below the USC market cap before the deficit can be addressed through USC burning via arbitrage or using the CHI/ETH liquidity. In such cases, USC minting and redemption are temporarily disabled, and Chi Protocol taps into its reserve fund's safety margins to cover any potential bad debts. This approach prioritises the protection of USC holders, with the protocol's treasury absorbing the loss to maintain their seniority as outlined in the collateral risk management strategy. 

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Before diving into this section, it is recommended to first review the [Dual Stability Mechanism](/chi-docs/concepts/dual-stability-mechanism-dsm.md) and [Collateral Risk Management](/chi-docs/concepts/collateral-risk-management.md) sections for a comprehensive understanding.
{% endhint %}

## How does the Chi Protocol manage bad debt risks? 

The Chi Protocol reserve fund is in place to step in when the USC amount in the arbitrage contract and the CHI/ETH liquidity are insufficient to close potential reserve deficits. This fund is designed to protect USC holders from bad debts, ensuring the stability and reliability of the protocol.

{% hint style="info" %}
In all of the examples below, we assume that the USC amount available for burning in the arbitrage contract and the ETH liquidity in the CHI/ETH pool are completely absent and, in order to cover the reserve deficit, direct intervention from the reserve fund is needed.
{% endhint %}

<figure><img src="/files/3B89qqIGWV5xePj7Pkq2" alt=""><figcaption></figcaption></figure>

{% hint style="success" %}
It is important to note that the size of the CHI/ETH liquidity is directly tied to the value of the protocol's reserves. The higher the reserves, the greater the incentives for providing liquidity.

Assuming that the USC in the arbitrage contract and the liquidity in the CHI/ETH pool are sufficient to cover reserve deficits, USC can maintain a 1:1 collateral ratio during market downturns without requiring any intervention from the reserve fund.\
\
[More on Liquidity Provision in CHI ](/chi-docs/chi/liquidity-provision-in-chi.md)
{% endhint %}

## **Case Study - August 5th 2024**&#x20;

On August 5th, 2024, Ether's price experienced a sharp decline of up to 22%, marking the largest one-day drop since May 2021.

<figure><img src="/files/WnQucG23qCGLCIpJCJsj" alt=""><figcaption><p>Protocol Response (August 5th 2024)</p></figcaption></figure>

For reference, see:

* [USC Dune Dashboards (USC burns dated August 5th 2024 )](https://dune.com/quackery/chi-protocol-usc)
* [CHI Dune Dashboard (CHI liquidity dated August 5th 2024)](https://dune.com/quackery/chi-protocol-chi)
* [Reserve Fund Intervention (USC Burn transaction from the reserve fund) ](https://etherscan.io/tx/0x028d34073880443875ad81daff940a6592a0a1c6693756b8d1e8cbf91571d5dd)


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