Aave V3 has effectively avoided bad debts, but this success has led to significant financial burdens for borrowers, according to a Bank of Canada study.
Aave V3, a decentralized finance (DeFi) platform, has effectively prevented the emergence of bad debts through its innovative lending mechanisms, but this success has come at a steep cost for borrowers, according to a new study by the Bank of Canada.
The analysis revealed that between January 27, 2023, and May 6, 2025, Aave V3 reported zero loan defaults, a feat attributed to its over-collateralization model and automatic liquidation processes. Smart contracts are designed to close positions before collateral values dip below the owed amounts, safeguarding lenders from potential losses.
Borrowers Bear the Risk
Despite the benefits for lenders, this system places significant risks on borrowers. The study highlighted that during volatile market conditions, liquidations occur swiftly and often at disadvantageous prices. Estimates suggest borrowers can incur losses of 5–10% of the liquidated asset's value in fees, and when factoring in missed opportunities from price recoveries, this can escalate to between 10% and 30%.
Furthermore, liquidations tend to happen in waves, intensifying market pressures. Roughly 90% of liquidated positions involve four specific tokens, primarily wrapped versions of Ethereum and Bitcoin, which creates a concentrated risk on the protocol linked to the fluctuations of these major cryptocurrencies.
Leverage Complicates Matters
The study also pointed out that the use of recursive lending—whereby collateral can be reused multiple times to boost loan amounts—adds another layer of risk. In 2024, this leveraged borrowing comprised over 20% of total borrowing volumes. While it can enhance borrowing capacity, it also heightens borrowers' exposure to price drops, leading to quicker and more severe liquidations.
DeFi Lending's Future
Bank of Canada analysts concluded that DeFi lending can function effectively without traditional intermediaries, with smart contracts managing liquidity and system stability. They stated, “Lending without traditional intermediaries is technically and operationally viable.”
However, challenges remain. The fragmentation of capital pools limits efficiency, and the requisite over-collateralization makes borrowing costly, constraining DeFi's broader application beyond the cryptocurrency sector. The study emphasized that while risks are not entirely eliminated, they are redistributed mainly to borrowers, highlighting the urgent need for regulatory clarity and traditional lending safeguards like capital requirements and leverage limits.
Notably, version V4 of the Aave protocol was launched on the Ethereum mainnet in March, indicating ongoing developments in the DeFi space.
