DeFi protocol AAVE faces bad debt and centralized points of failure

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 E TH, 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.

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.

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