Jolly Cobalt Ant Protocol: Bad Debt Handling Vulnerability

Aug 14, 2025 by Chloe Fitzgerald 59 views

Jolly Cobalt Ant Protocol: Missing Bad Debt Handling in Liquidate Function Vulnerability

Hey guys! Today, we're diving deep into a critical vulnerability discovered in the Jolly Cobalt Ant protocol. This issue, identified in the liquidate function, could lead to significant problems with bad debt management. Let's break it down, make it super clear, and see how this can impact the protocol and its users.

Understanding the Vulnerability

In this deep dive, we're tackling a crucial issue: the missing bad debt handling mechanism in the _liquidate function of the Jolly Cobalt Ant protocol. This flaw, uncovered during a Sherlock audit, can lead to serious financial instability if left unaddressed. Essentially, the protocol doesn't properly manage situations where a borrower's collateral isn't enough to cover their debt, which can result in accumulated bad debt and potential losses for lenders. We will discuss the technical aspects of this vulnerability, its potential impact, and provide clear recommendations on how to fix it. So, let's get started and ensure our protocols are as robust and secure as possible!

The Technical Deep Dive

The heart of the issue lies within the _liquidate function. This function is responsible for handling liquidations, which occur when a borrower can't repay their loan. The function is designed to seize collateral and repay the debt. However, it lacks a critical component: a mechanism to handle scenarios where the collateral's value is less than the outstanding debt. This omission can create a cascade of problems.

Let's look at the code snippet to understand better:

    function _liquidate(
        address liquidator,
        address borrower,
        uint256 repayAmount,
        address mTokenCollateral,
        bool doTransfer
    ) internal nonReentrant {
        _accrueInterest();

        ImToken(mTokenCollateral).accrueInterest();

        // emits borrow-specific logs on errors, so we don't need to
        __liquidate(liquidator, borrower, repayAmount, mTokenCollateral, doTransfer);
    }

The function calls __liquidate, where the actual liquidation logic resides. The vulnerability becomes apparent when we examine this __liquidate function. It calculates the amount of collateral to seize and transfers it, but it doesn't account for situations where the borrower's total debt exceeds the collateral value. Any remaining unpaid debt simply stays with the borrower, without being distributed across the protocol. This is where the problem begins to snowball.

Here’s the relevant code snippet from the __liquidate function:

function __liquidate(
        address liquidator,
        address borrower,
        uint256 repayAmount,
        address mTokenCollateral,
        bool doTransfer
    ) internal {
        require(borrower != liquidator, mt_InvalidInput());
        require(repayAmount > 0 && repayAmount != type(uint256).max, mt_InvalidInput());

        IOperatorDefender(operator).beforeMTokenLiquidate(address(this), mTokenCollateral, borrower, repayAmount); // @remind here the liquidator address is not passed.

        require(
            ImToken(mTokenCollateral).accrualBlockTimestamp() == _getBlockTimestamp(),
            mt_CollateralBlockTimestampNotValid()
        );

        /* Fail if repayBorrow fails */
        uint256 actualRepayAmount = __repay(liquidator, borrower, repayAmount, doTransfer);

        /////////////////////////
        // EFFECTS & INTERACTIONS
        // (No safe failures beyond this point)

        /* We calculate the number of collateral tokens that will be seized */
@>      uint256 seizeTokens =
            IOperator(operator).liquidateCalculateSeizeTokens(address(this), mTokenCollateral, actualRepayAmount);

        /* Revert if borrower collateral token balance < seizeTokens */
        require(ImToken(mTokenCollateral).balanceOf(borrower) >= seizeTokens, mt_LiquidateSeizeTooMuch());

        // If this is also the collateral, run _seize to avoid re-entrancy, otherwise make an external call
        if (address(mTokenCollateral) == address(this)) {
            _seize(address(this), liquidator, borrower, seizeTokens);
        } else {
            ImToken(mTokenCollateral).seize(liquidator, borrower, seizeTokens);
        }

        /* We emit a LiquidateBorrow event */
        emit LiquidateBorrow(liquidator, borrower, actualRepayAmount, address(mTokenCollateral), seizeTokens);
    }

The Missing Link: Bad Debt Socialization

The key here is the lack of a bad debt socialization mechanism. In a healthy lending protocol, when a borrower defaults, the resulting bad debt should be distributed across the protocol's participants, usually the lenders. This ensures that the risk is shared and no single party bears the entire brunt of the loss. Without this mechanism, the bad debt accumulates, creating a ticking time bomb.

Impact: Why This Matters

The impact of this vulnerability is far-reaching and can significantly destabilize the Jolly Cobalt Ant protocol. Let's break down why this is such a big deal:

Accumulation of Bad Debt

The most immediate impact is the accumulation of bad debt. When borrowers default and their collateral doesn't cover their debt, the unpaid amount remains on their account. This debt isn't erased or distributed; it simply sits there, growing over time. As more borrowers default, the total amount of bad debt escalates, eroding the protocol's financial health. This accumulation can create a significant liability, making the protocol look less attractive to new users and lenders.

Unfair Loss Distribution

Without a proper socialization mechanism, the losses from bad debt are not distributed fairly. Instead of spreading the risk among all participants, lenders end up bearing the brunt of undercollateralized debt. This creates a scenario where some users are disproportionately affected by the defaults of others. This unfair distribution can lead to resentment and a loss of confidence in the protocol, as users realize they are shouldering more risk than they initially anticipated. Imagine being a lender who diligently provided funds, only to see your returns diminished by the bad debts of others – it's a recipe for dissatisfaction.

Risk of Bank Runs

Perhaps the most severe consequence is the potential for bank runs. If users realize that the protocol is holding a substantial amount of worthless debt positions, they might rush to withdraw their funds. This sudden mass withdrawal can deplete the protocol's reserves, making it difficult to meet all withdrawal requests. The resulting panic can trigger a complete collapse of the protocol, as trust erodes and liquidity dries up. No one wants to be the last one out when the music stops, so the fear of being stuck with worthless assets can drive users to withdraw their funds at the first sign of trouble.

Eroded Protocol Reputation

Beyond the immediate financial impacts, this vulnerability can severely erode the protocol's reputation. Trust is the cornerstone of any DeFi project, and a failure to manage bad debt effectively can shatter that trust. Once users lose confidence in the protocol's ability to handle risk, it's incredibly difficult to win them back. The negative publicity surrounding a major vulnerability can linger for a long time, making it harder to attract new users, secure partnerships, and maintain the protocol's long-term viability. In the competitive world of DeFi, reputation is everything.

Proof of Concept (POC)

To illustrate how this vulnerability works, let's walk through a simple Proof of Concept (POC):

Liquidator Repays Portion of Debt: A liquidator steps in to repay a portion of a borrower's debt.
Protocol Seizes Proportional Collateral: The protocol seizes an amount of collateral proportional to the debt repaid.
Remaining Debt Stays with Borrower: The crucial point here is that any remaining debt, not covered by the seized collateral, remains with the borrower.
No Socialization Mechanism: There is no mechanism to distribute this bad debt across the protocol. It simply accumulates, creating a growing problem.

This POC highlights the core issue: the lack of a socialization mechanism allows bad debt to fester, potentially leading to the dire consequences we discussed earlier. It's like a slow-motion financial disaster waiting to happen.

Recommendation: Distribute the Debt

So, what's the fix? The core recommendation is straightforward: implement a mechanism to distribute debt equally across all users. This is the linchpin of a robust and fair lending protocol. Here’s a more detailed breakdown of how this can be achieved:

Implementing a Socialization Mechanism

To effectively address the bad debt issue, the protocol needs a socialization mechanism. This mechanism ensures that losses from undercollateralized loans are shared among the protocol's participants, typically the lenders. This approach mitigates the risk of concentrated losses and promotes a more stable and equitable lending environment. Think of it as spreading the cost of an accident across an insurance pool rather than leaving one person to foot the entire bill.

How to Distribute Debt

There are several ways to distribute debt, each with its own set of considerations. Here are a few common methods:

Debt Auction: One approach is to auction off the bad debt to the highest bidder. Specialized debt buyers or other participants in the ecosystem can purchase the debt at a discounted rate. This method allows the protocol to recover some value from the bad debt while transferring the risk to those who are willing to take it. It’s a bit like selling off distressed assets to recoup some of the losses.
Debt Tokenization: Another strategy is to tokenize the bad debt, creating a tradable asset that represents a claim on the debt. This allows the protocol to distribute the debt more broadly and provides an opportunity for market participants to speculate on its potential recovery. Think of it as turning a liability into a potentially valuable asset that can be bought and sold.
Proportional Distribution: The most common method involves distributing the debt proportionally among the lenders in the protocol. This ensures that each lender bears a share of the loss relative to their contribution. For example, if a lender provided 10% of the total funds, they would absorb 10% of the bad debt. This method is straightforward and equitable, ensuring that the risk is shared fairly.

Proportional Distribution in Detail

Let’s dive deeper into the proportional distribution method, as it’s the most straightforward and equitable approach. Here’s how it works:

Calculate Total Debt: First, the protocol calculates the total amount of bad debt resulting from the liquidation.
Determine Lender Shares: Next, it determines each lender’s share of the total debt based on their contribution to the lending pool. This is typically calculated as the percentage of their deposited funds relative to the total funds in the pool.
Adjust Lender Balances: Finally, the protocol adjusts each lender’s balance to reflect their share of the bad debt. This might involve reducing the amount of tokens they are entitled to withdraw or issuing a special token that represents their share of the debt.

Code Implementation Considerations

Implementing a debt distribution mechanism requires careful coding and testing. Here are some key considerations:

Gas Efficiency: Distributing debt across a large number of users can be gas-intensive. The implementation should be optimized to minimize gas costs and prevent the process from becoming prohibitively expensive.
Security Audits: Any code changes related to debt distribution should undergo rigorous security audits to ensure they are free from vulnerabilities. This is crucial to prevent exploitation and protect the protocol's funds.
Transparency: The debt distribution process should be transparent and easily auditable. Users should be able to verify how the debt was distributed and ensure that the process was fair.

By implementing a robust debt distribution mechanism, the Jolly Cobalt Ant protocol can significantly enhance its resilience and protect its users from the adverse effects of bad debt. This proactive approach will foster trust and confidence in the protocol, paving the way for long-term success.

Conclusion

In summary, the lack of a bad debt handling mechanism in the _liquidate function is a critical vulnerability that could lead to significant financial instability for the Jolly Cobalt Ant protocol. Accumulated bad debt, unfair loss distribution, and the potential for bank runs are all serious consequences. Implementing a mechanism to distribute debt equally across all users is the key recommendation to address this issue. By taking proactive steps to manage bad debt, the protocol can enhance its resilience, foster trust, and ensure its long-term viability. Keep your protocols secure, guys!