The Aave community is worried that more users will borrow ether before the Merge, which could cause liquidity problems for the protocol and make the staked ether market on Lido more volatile.
Aave, a large decentralized lending platform, has put in place new rules to protect itself from a number of risks that could come from an increase in the number of crypto traders who want to borrow ether (ETH) to bet on the upcoming technological update to the Ethereum blockchain.
Between August 30 and September 2, the Aave community voted overwhelmingly to stop lending ether. This went against the free market principle of democratized finance, but it was done to reduce protocol-wide risks that could come from Ethereum’s upcoming “Merge” from a proof-of-work (PoW) consensus mechanism to a proof-of-stake (PoS) one. The update should happen between Sept. 13 and 15.
“Before the Ethereum Merge, there is a chance that the Aave protocol will be used a lot in the ETH market. “This risk of high usage will be reduced if ETH borrowing is put on hold for a while,” said the research firm Block Analitica’s proposal.
The use rate is the amount of the pool that has been loaned out. Users could borrow ETH before the Merge to get free money or the possible Ethereum fork token ETHPOW. This means that the rate is likely to go up.
Some Ethereum miners are against the planned switch to PoS and want to split the chain into a PoS chain and a PoW chain. A PoW chain’s native token would be ETHPOW, which would be given away for free to anyone with ETH.
A researcher at Binance.US named Ian Unsworth said that people are borrowing ETH from lending protocols, especially AAVE. Bobby Ong of CoinGecko said that if the trend keeps going, the already high rate of over 70% could go up to 100%.
Liquidations will be hard because of their high usage.
If the utilization rate goes up, it means that most of the ETH has been loaned out. This means that there isn’t much ETH left for liquidators to use as collateral for regular liquidations of ETH borrow-based positions.
“High utilization gets in the way of liquidation transactions, which makes it more likely that the protocol will go bankrupt,” Block Analytica said in the proposal.
Ian Solot, a partner at crypto hedge fund Tagus Capital, said that the borrowing suspension was a good idea, but that “part of the problem is that if markets become very volatile and ETH borrowers need to be liquidated, there may not be enough ETH because it is being used so much,” which would make it harder for liquidations to go through smoothly.
Liquidations are when positions have to be closed because the value of the collateral has gone down. Aave says that liquidations happen when a borrower’s health factor drops below 1 because the value of their collateral doesn’t cover the value of their loan or debt.
ETH-funded trades that go back and forth lose their appeal.
The rise in the use rate could make it so that the popular ETH-stETH recursive borrowing positions on Aave are no longer profitable. This could cause a lot of people to close their positions, which would make the stETH market more volatile.
In recursive trades, users send ETH to the liquid staking protocol Lido in exchange for the staked ether token (stETH), which is then used as collateral on Aave to borrow more ETH. This borrowed ETH is sent back to Lido to get more stETH, which is then sent back to AAVE as collateral to borrow more ETH. The cycle keeps going. This leveraged position, which is similar to carry trading, loses its appeal when the interest rate for borrowing ETH goes above the annualized reward for staking, which is 3.9% on Lido right now.
“Once the ETH borrow rate reaches 5%, which happens soon after the 70% utilization rate, stETH/ETH positions start losing money,” Block Analytica said in the Aave ETHPOW risk mitigation plan that came out last month. “This means that a lot of stETH would be redeemed for ETH, which would put pressure on the price of stETH, which is already going down because regular stETH holders are switching to ETH to profit from ETHPoW work.
“All of this can cause stETH’s price to go down in a spiral, which can lead to a chain of liquidations at Aave,” said Block Analytica.
According to a tweet by Binance.Unsworth, US’s the largest ETH borrower on AAVE and the two second-largest ETH borrowers both have stETH as collateral. At the time of publication, more than $900 million worth of stETH was locked on AAVE as collateral for people who wanted to borrow ETH.
Aave also runs the risk of liquidity providers for wrapped ether (wETH) pulling out coins to get ready for a possible Ethereum fork token called ETHPOW. Some people in the community aren’t sure if stopping people from borrowing ETH would help solve this possible problem.