
The lending market has been frozen since November 2022 but limited Liquidity For 0x Protocol's governance token could resulting in bad debt if ZRX drops sharply.
As DeFi's liquidity continues to decline, major lending protocols continue to grapple with how to manage outstanding loans against long-tail assets that have been battered by the bear market.
A wallet with an outstanding loan of $2.5 million on Aave V2 against roughly $8M worth of ZRX could face liquidation if the price of ZRX drops by 22%.
Aave V2 is the previous version of DeFi's leading money market with more than $4.5B in total value locked. ZRX, the governance token of 0x Protocol, is the most popular Matcha DEX aggregator. DeFi's stock is down more than 90% from its peak in April 2021.
Although Aave has been taking steps to mitigate the risks posed by illiquid collateral through a series of risk factor adjustments that started in 2021 and hiked the liquidation threshold for ZRX so recently as August, a sudden drop in ZRX's price could have sparked Aave with bad debt. However, it should be noted that the borrower has been actively maintaining the position and has repaid $470,000 in the past month.
Matcha, a DEX aggregator that spreads trades across all liquid sources to obtain the best prices, recommends the ZRX token's limited on-chain liquidity - a sale of only 1M ZRX would result in a 60% loss in value due to slippage, according to Matcha, a DEX aggregator that spreads trades across all sources of liquidity to obtain the best prices. Even a partial liquidation would likely require more than 1M ZRX to be sold - the borrower holds over 47M ZRX.
Coingecko adds that although ZRX is listed on centralized exchanges like Binance, there is limited liquidity available there.
The low liquidity means even if the borrower becomes eligible for liquidation due to a sudden drop in ZRX, no rational actor has an incentive to liquidate the wallet.
To liquidate a Aave position, one must pay back the borrowed asset in exchange for receiving the defaulted collateral at a discount. Liquidators frequently sell the seized collateral immediately for a guaranteed profit.
Liquidators receive a 7.5% bonuses in ZRX when they liquidate a ZRX market, according to a Snapshot vote approved by Aave governance in 2021.
The poor liquidity would make liquidating the position unprofitable, as the slippage on a major sale of ZRX far outweighs the bonus received by the liquidator.
If ZRX drops sharply, and the borrower doesn't take action to save the position, Aave could be left with bad debt.
Aave said it will sell AAVE tokens from its Safety Module in cases of bad debt, according to the protocol's documentation. holders of AAVE are encouraged to stake their tokens in the Safety Module to earn more AAVE tokens in the form of more tokens.
Any potential bad debt isn't likely to sink Aave - AAVE's safety module holds $235M of staked AAVE. The program also brings in annualized revenue of $17.2M, according to Token Terminal.
Aave governance froze the ZRX market last November after Avraham Eisenberg, a renowned proponent of 'highly profitable trading strategies, left the protocol with $1.6 million in bad debt. The market of ZRX isn't visible on Aave V2's interface, though it's visible on-chain.
A frozen market means users can either borrow or deposit a given asset, according to Aave's documentation. Only loan repayments are allowed.
According to Snapchat's vote last month, the position will be eligible for liquidation, with ZRX down to 39%, up from 45%.
The borrower has been making regular repayments - the most recent one being $110,000 two days ago. Two other repayments totaling $360,000 were also made this month.
The address's first deposit of 12M ZRX, worth more than $6M at the time, was made to Aave V2 on Jan. 22, 2022, according to a query from Transpose, a company that provides blockchain analytics.
The wallet holds nearly 98% of the ZRX secured on Aave, according to Etherscan.
The 47.1M ZRX tokens will represent the sixth largest amount held by one wallet, however, the block explorer aggregates all collateralized ZRX tokens, known as aZRX, into a single block of 47.6M tokens.
Aave and 0x declined to comment when The Defiant asked representatives of the projects about the collateralized position.