DeFi protocol AAVE faces bad debt and centralized points of failure

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AAVE has a bad debt prob­lem. A glob­al com­mu­ni­ty of peo­ple use the AAVE pro­to­col to take out and ser­vice cryp­to loans, pro­vide liq­uid­i­ty, stake, earn inter­est, and/or vote on gov­er­nance proposals.

But as a result of these finan­cial deal­ings, the AAVE pro­to­col itself has debt — payable in the future to AAVE from its users. The prob­lem? Some of those debts might have gone bad.

AAVE cur­rent­ly boasts more than $6 bil­lion in cryp­to val­ue on its plat­form. Its so-called ‘V2’ imple­men­ta­tion cur­rent­ly has $5.5 bil­lion in Total Val­ue Locked (TVL), a com­mon­ly-cit­ed (albeit easy-to-manip­u­late) mea­sure of DeFi pro­to­cols. That TVL includes $5.16 bil­lion in ETH and ETH-based tokens, $669 mil­lion in wrapped ether (WETH), and $546 mil­lion in wrapped bit­coin (WBTC).

DeFiLla­ma, a pop­u­lar met­rics web­site, tal­lies $1.7 bil­lion of that $5.5 bil­lion total as bor­rowed. The web­site also list­ed $350.3 mil­lion as assets able to be imme­di­ate­ly liq­ui­dat­ed — the sec­ond high­est of any DeFi appli­ca­tion.

DeFiLla­ma also cit­ed an AAVE-con­trolled Ethereum wal­let that cur­rent­ly holds $144 mil­lion worth of tokens, most of it AAVE-wrapped ether (aWETH) and AAVE-wrapped bit­coin (aWBTC).

Trans­ac­tion data from this address indi­cates that the wal­let receives high-val­ue ETH trans­ac­tions from cen­tral­ized exchanges like Bitfinex. It also fre­quent­ly inter­acts with one of Centre’s offi­cial USD Coin wal­lets. On Novem­ber 21, for exam­ple, it received three trans­ac­tions worth 1,250 ETH, slight­ly over 16,622 ETH, and almost 10,000 ETH, direct­ly from a Bitfinex hot wallet.

An Ethereum address labeled in Ether­scan as Aave: Gen­e­sis Team cur­rent­ly holds $82 mil­lion in Ethereum tokens. A recent snap­shot by DeBank put its val­ue at $74 mil­lion and $7 bil­lion worth of USDC-owed debt.

The Aave: Gen­e­sis Team wal­let inter­est­ing­ly received a trans­fer of 7.2 mil­lion USDC on Novem­ber 17, 2022. It quick­ly trans­ferred 7 mil­lion USDC to AAVE V2 in a trans­ac­tion labeled ‘repay.’ These trans­ac­tions indi­cate that the address’s con­troller is pulling USDC off an exchange to pay off the loan.

With so many cen­tral­ized points of con­trol, includ­ing cen­tral­ized exchange accounts con­trolled by one per­son, the AAVE com­mu­ni­ty is begin­ning to won­der not only whether its debtors are cred­it­wor­thy, but also who even con­trols the protocol’s assets.

The bank­rupt­cy of FTX has impaired the assets of many of AAVE’s debtors. Bil­lions of dol­lars will remain locked in bank­rupt­cy pro­ceed­ings for months, and these assets can­not be imme­di­ate­ly repaid to AAVE. At the worst, fear could spark a bank run as depos­i­tors try to with­draw their assets from the pro­to­col en masse.

AAVE also faces the risk of loan­ing addi­tion­al dig­i­tal assets to bor­row­ers who can­not repay. AAVE’s $1.7 bil­lion in bor­rowed assets may indi­cate con­sid­er­able lever­age trad­ing on dig­i­tal asset exchanges. Of course, lever­age comes with high risks, includ­ing los­ing mon­ey on a bad bet or even los­ing access to one’s assets when an exchange melts down as rapid­ly as FTX did.

Read more: DeFi pro­to­cols are lim­it­ing Ether bor­row­ing — here’s why

Bad debt could haunt AAVE and its users, espe­cial­ly if mar­kets have anoth­er sig­nif­i­cant down­turn. AAVE could even­tu­al­ly be look­ing to dis­pose of bil­lions of dol­lars’ worth of illiq­uid col­lat­er­al. The protocol’s bil­lions of sup­posed TVL could end up plum­met­ing rapid­ly through a wors­en­ing bear mar­ket, a bank run-like pan­ic, or both.

For more informed news, fol­low us on Twit­ter and Google News or lis­ten to our inves­tiga­tive pod­cast Inno­vat­ed: Blockchain City.



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