Aave V3 Avoided Bad Debt by Shifting Risk to Borrowers, Bank of Canada Study Finds

A Bank of Canada study examined decentralized lending protocol Aave V3, which requires borrowers to pledge crypto assets worth more than their loans and automatically liquidates positions when collateral ratios deteriorate. The design reduces lenders’ exposure to credit losses, but leaves borrowers bearing price volatility and liquidation losses. It is also less capital-efficient than the traditional financial system.

The Bank of Canada’s review of Aave V3’s operations in 2024 found that overcollateralization and automatic liquidations allowed the protocol to avoid bad debt entirely, leaving the total at 0. The study stressed that the risk did not disappear but was instead absorbed by borrowers. If collateral prices fall, borrowers can be liquidated quickly and incur related costs.