Aave V2's limited Liquidity could lead to bad debt

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Aave V2's limited Liquidity could lead to bad debt

Since November 2022, the lending market has been frozen, but Limited Liquidity For 0x Protocol's governance token could resulting in bad Debt if ZRX drops sharply.

While DeFi's liquidity continues to dwindle, 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 amounting to $2.5 million in Aave V2 against roughly $8M worth of ZRX could face liquidation if the price of ZRX drops by 22%.

The previous version of DeFi's leading money market, Aave V2 is the previous version of DeFi's leading money market with over $4.5B in total value locked. ZRX, the governance token of 0x Protocol, powers the popular Matcha DEX aggregator. Like most DeFi assets, it's down more than 90% from its peak in April 2021.

While Aave has been taking steps to mitigate the risk posed by illiquid collateral through several risk factor adjustments that began in 2021, the liquidation threshold for ZRX has been increased as recently as August, causing a sudden drop in the price of ZRX to lead to bad debt. It should be noted, however, that the borrower has been actively maintaining the position and has repaid $470,000 in the past month.

A sale of just 1M ZRX would result in a 60% loss in value due to slippage, according to Matcha, a DEX aggregator that spreads trades across all liquids 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 said that while ZRX is listed on centralized exchanges like Binance, there is limited liquidity available there.

Even if the borrower is eligible for liquidation due to a sudden drop in ZRX, no rational actor has an incentive to liquidate the wallet.

To liquidate a position on Aave, one must pay back the loaned asset at a discount to receive the defaulted collateral. Liquidators frequently sell the seized collateral for a guaranteed profit.

Liquidators receive a 7.5% bonus in ZRX when they liquidate a ZRX market, according to a Snapshot vote approved by Aave governance in 2021.

The liquidity would make liquidating the position unprofitable - the slippage on a major sale of ZRX far outweighs the bonus received by the liquidator.

If the borrower fails to save Aave's position, the borrower is likely to be left with bad debt.

Aave will sell AAVE tokens from its Safety Module to cover the deficit, according to the protocol's documentation. Holders of AAVE are encouraged to stake their tokens in the Safety Module to earn rewards in the form of more AAVE tokens.

Any potential bad debt isn't likely to sink Aave - the safety module holds $235M of staked AAVE. The program also brings in revenue of $17.2 million, 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. As such, the ZRX market doesn't appear 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.

The position will be eligible for liquidation, according to a Snapshot vote last month that raised the liquidation threshold of ZRX to 39% from 45%.

The borrower has been making regular repayments - the most recent one being $110,000 two days ago. Three other repayments, totalling $360,000, were also made in the month of March.

The address made its first deposit of 12M ZRX, worth more than $6M at the time, to Aave V2 on Jan. 22, 2022, according to a query from Transpose, a company that provides blockchain analytics.

The wallet holds 98% of the ZRX secured by Aave, according to Etherscan.

The block explorer aggregates all collateralized ZRX tokens, called aZRX, into a single block of 47.6M tokens, according to Etherscan.

Aave and 0x declined to comment when The Defiant asked representatives of the projects about the collateralized position.