Update April 7, 2026, 6:37 am UTC: This article has been updated to add comments from an Aave spokesperson.
Update April 8, 2026, 7:40 am UTC: This article has been updated to include additional context from the Bank of Canada paper.
A Bank of Canada staff paper found that Aave V3 reported zero non-performing loans in 2024, with overcollateralization and automated liquidations helping prevent lender losses in its Ethereum lending market.
Using transaction-level data from Jan. 27, 2023, to May 6, 2025, the study found that positions were typically liquidated before collateral values fell below outstanding debt, helping contain lender losses across the sample.
But the model came with a tradeoff, the paper said. While it protected lenders from unrecovered losses, it also shifted risk onto borrowers and constrained capital efficiency compared with traditional lending systems.
According to the paper, Aave V3’s design relies on automated risk controls rather than traditional underwriting, requiring borrowers to post more collateral than they borrow and liquidating positions when they breach risk thresholds. The study described liquidations as a core risk-control mechanism in permissionless lending, where protocols cannot rely on underwriting or legal enforcement.
Recursive leverage fueled borrowing demand
According to the paper, Aave V3’s lending activity was not driven solely by users seeking liquidity. It found that recursive leverage accounted for over 20% of total borrowed volume and 8.2% of borrowing 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.
Related: Aave V4 goes live on Ethereum after governance vote clears rollout
The study said the dynamic made borrowers more exposed when markets turned. According to the paper, liquidations on Aave V3 tended to occur in concentrated waves, with four assets accounting for 90% of total liquidated value. The paper said those liquidation events appeared largely contained, finding no statistically significant evidence that they caused persistent broader market price effects.
This includes Wrapped Ether (WETH), Wrapped Staked Ether (wstETH), Wrapped Bitcoin (WBTC) and Wrapped eETH (weETH).
The paper estimated that borrower losses during major liquidation events could be significant. It said direct liquidation fees typically ranged from 5% to 10% of liquidated value, while missed gains from subsequent price recoveries pushed combined losses to about 10% to 30% in some cases.
The staff paper suggested that while the design for Aave V3 helped prevent unrecovered bad debt in the sample, it did so by exposing borrowers to abrupt losses when collateral prices fell sharply.
The paper nonetheless described DeFi lending as operationally viable, citing transparency, automation and low-cost execution as key strengths.
Aave says its newer design aims to make liquidations more gradual
Aave defended its liquidation-based model, framing it as a core safety mechanism. “Aave avoids bad debt through orderly liquidations,” an Aave spokesperson told Cointelegraph, adding that automated processes help protect lenders and the protocol while limiting downside for borrowers.
The company said borrower risk is visible in real time through the protocol's health factor, allowing users to monitor and manage positions before liquidation thresholds are breached.
Aave said its V4 upgrade is designed to make liquidations more responsive to market conditions. The spokesperson said that the new system introduces variable liquidation bonuses that increase as risk rises, encouraging faster intervention on distressed positions.
According to the company, these changes are intended to make liquidations more gradual and reduce unnecessary borrower losses during volatility while preserving the protocol’s risk controls.
Magazine: Are DeFi devs liable for the illegal activity of others on their platforms?