Aave V3 Avoided Bad Debt in 2024, but Shifted Risk to Borrowers: Bank of Canada Study

A Bank of Canada staff paper revealed that Aave V3 successfully avoided bad debt in 2024 by implementing a risk-shifting model that transferred losses to borrowers during liquidations. The study, which analyzed transaction-level data from January 27, 2023, to May 6, 2025, found that the protocol's overcollateralization and automated liquidations prevented lender losses in its Ethereum lending market. However, the model's design, which relies on automated risk controls rather than traditional underwriting, required borrowers to post more collateral than they borrowed. This approach protected lenders but exposed borrowers to abrupt losses when collateral prices fell sharply. The study also highlighted that Aave V3's lending activity was not solely driven by users seeking liquidity. It found that recursive leverage accounted for over 20% of total borrowed volume and 8.2% of borrow transactions during the sample period. Recursive leverage involves repeatedly borrowing against collateral, redeploying the borrowed assets as new collateral, and borrowing again to amplify exposure. This dynamic increased borrower risk when markets turned volatile. The paper noted that liquidations on Aave V3 tended to occur in concentrated waves, with four assets—Wrapped Ether (WETH), Wrapped Staked Ether (wstETH), Wrapped Bitcoin (WBTC), and Wrapped eETH (weETH)—accounting for 90% of total liquidated value. During major liquidation events, borrower losses could be significant, with liquidation fees typically ranging from 5% to 10% of liquidated value. Missed gains from subsequent price recoveries further pushed combined losses to about 10% to 30% in some cases. The study concluded that while Aave V3's design helped prevent unrecovered bad debt in the sample, it did so by exposing borrowers to abrupt losses when collateral prices fell sharply.