After the KelpDAO hack, AAVE's situation is worse than you think
Original Author: Duo Nine
Original Compilation: Deep Tide TechFlow
I don't think people realize how bad the situation with @aave is right now.
All core markets have reached 100% utilization, which includes $3 billion in USDT and $2 billion in USDC being stuck!
This means you cannot withdraw your funds.
A lengthy article explaining why and how we got to this point.
When the rsETH vulnerability occurred and AAVE generated bad debts, individuals like Justin Sun, MEXC exchange, and other whales immediately withdrew billions from AAVE.
This instantly drained all available liquidity from key core markets like ETH, USDT, and USDC. Those who withdrew first escaped, while those who were a step behind got trapped.
Initially, the ETH market reached 100% utilization, meaning you could not withdraw your ETH from AAVE.
Worse still, this also means the protocol cannot handle ETH liquidations if the ETH price drops/crashes. If you cannot sell any ETH, you cannot liquidate to cover debt obligations.
This means AAVE faces an increasing risk of generating more bad debts as its markets remain stuck.
Nevertheless, users can still sell aETHwETH tokens at a small loss on Uniswap or similar aggregators. This is the last exit door for ETH depositors on AAVE.
Depositors of USDT and USDC cannot do this. They are trapped.
This is because AAVE has lost over $6 billion in liquidity in the past 24 hours. As whales withdrew their funds, USDT and USDC also reached 100% utilization.
These markets are now also stuck, with funds locked. Panic is spreading, and desperate measures are needed in this critical moment.
Some users decided to borrow USDT/USDC as collateral to exit through other markets at a 10-25% loss (90-75% LTV). Essentially, you borrow GHO/DAI/USDe to counteract your locked USDT/C.
But as more liquidity leaves AAVE, more markets reach 100% utilization and become locked/stuck due to low liquidity. This is rapidly spreading to all available markets.
Fortunately, the crypto market is relatively stable today, so the risk of liquidation is minimal, but if the situation changes, the billions of dollars in stablecoins and other assets locked on AAVE will not be able to handle liquidations = more bad debts for AAVE.
If trapped users or related protocols need access to their funds to prevent liquidations or other critical functions, they will face significant problems.
Moreover, no one wants to deposit (or provide liquidity) in these markets right now, as your ETH, BTC, USDC/T could get stuck there, and who knows for how long.
Once any available liquidity appears, it is immediately snatched away by bots rushing to escape. As I write this article, I saw $250,000 in USDC liquidity disappear in seconds.
Then there’s the bad debt issue.
AAVE has generated over $200 million in bad debts through rsETH, which is like a hot potato. No one knows who will ultimately foot the bill.
If you haven't removed your assets from AAVE, you risk receiving a portion of this bill in some form. Not being able to access your funds is also part of this risk.
The contagion is also very high.
Many protocols and applications rely on AAVE to realize their earning mechanisms. These protocols and their users are also trapped and may be forced to generate bad debts for no reason.
October 10 was a CEX-driven crash, an epic failure of DeFi risk mitigation.
AAVE should never have introduced rsETH as a collateral asset, at least not on the scale of hundreds of millions, which allowed hackers to borrow over $200 million in ETH after releasing fake collateral.
Rumors on X suggest that rsETH was introduced by AAVE due to a conflict of interest (lobbying) with a service provider. If true, this is a significant failure of its governance structure (nothing new).
The team managing rsETH, @KelpDAO, is also facing a tough decision: who will truly pay for the $200 million vulnerability? AAVE users? L2 rsETH users? Will everyone affected have to be shaved to cover the losses?
The AAVE team and its founder Stani have remained silent for over 20 hours since initially announcing the freeze of the rsETH market after the vulnerability occurred.
They have a considerable problem on their hands, as the entire protocol is now at risk. Trust has been lost, as AAVE's TVL is draining billions of dollars, causing all core markets to reach 100% utilization.
Perhaps some key players in the space will step in to provide liquidity to stabilize the markets on AAVE before the situation worsens.
I was fortunate to escape AAVE early when I first saw this. I also removed all assets from DeFi and will not touch any protocols in the coming weeks. The risk is too high for a few percentage points of gain.
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