The lending mechanisms of the DeFi protocol Aave version V3 have successfully prevented the accumulation of bad debts, but this has come at a significant cost to borrowers. This conclusion was reached by analysts at the Bank of Canada.
According to a study, from January 27, 2023, to May 6, 2025, Aave V3 recorded no instances of loan defaults. This was made possible by its over-collateralization model and automatic liquidations.
Typically, smart contracts close positions before the value of the collateral falls below the debt amount, protecting lenders from losses.
Risk Shifted to Borrowers
However, this architecture has a downside. Bank analysts noted that the system effectively shifts risks onto borrowers, who bear the brunt of losses during market downturns.
During periods of high volatility, liquidations occur rapidly and often at unfavorable prices. Experts estimate that users typically lose 5–10% of the liquidated position's value in fees. When accounting for lost potential from subsequent price recoveries, this figure can reach 10–30%.
Moreover, liquidations are uneven, occurring in waves that increase market pressure. Approximately 90% of closed positions involve a set of four tokens, which are wrapped versions of Ethereum and Bitcoin. This leads to risk concentration and the protocol's dependence on the dynamics of the two largest crypto assets.
Ethereum dynamics and major liquidation waves on Aave V3. Source: Bank of Canada.
The Role of Leverage
Another risk factor is the widespread use of so-called recursive lending. This mechanism allows collateral assets to be reused multiple times to increase the loan amount.
This type of leverage accounted for over 20% of total borrowing volume in 2024. However, leverage amplifies users' vulnerability when collateral prices drop, increasing the system's sensitivity to market shocks and accelerating cascading liquidations.
Potential of DeFi Lending
Based on their analysis of Aave V3, Bank of Canada specialists noted that DeFi lending can already operate without intermediaries—smart contracts effectively allocate liquidity and maintain system stability.
“Lending without traditional intermediaries is technically and operationally viable,” they acknowledged.
However, the model has several key limitations. Firstly, part of the capital remains underutilized due to pool fragmentation, reducing overall efficiency. Secondly, over-collateralization makes loans expensive and limits DeFi's application outside the crypto market.
The system does not eliminate risks but redistributes them—primarily onto borrowers. Analysts consider the lack of clear regulation in the sector and traditional lending rules, such as capital requirements, leverage limits, or liquidity thresholds, to be significant issues.
Recall that in March, developers launched version V4 of the protocol on the Ethereum mainnet.