The Aave community is concerned that users will borrow ether ahead of the Merge, causing liquidity issues and volatility in Lido’s staked ether market.
Large decentralized lending platform Aave has instituted new restrictions to safeguard itself from many threats that could arise from an increase in the desire to borrow ether (ETH) from cryptocurrency speculators placing bets on the impending technological makeover of the Ethereum blockchain.
Between August 30 and September 2, the Aave community voted overwhelmingly to cease ether lending, abandoning the free market principle of democratized finance in order to reduce protocol-wide risks associated with Ethereum’s impending Merge from a PoW to a PoS consensus method.
We anticipate performing the upgrade between September 13 and 15.
“The Aave protocol could see heavy usage in the ETH market just before the Ethereum Merge. Suspending ETH borrowing for the time being will reduce the likelihood of this happening “Block Analitica, a research group, emphasized this suggestion.
In this context, “utilization rate” means the proportion of the pool that has been borrowed from. To get free money or the possible Ethereum fork token ETHPOW, users could borrow ETH before the Merge, driving up the rate.
There are Ethereum miners that disagree with the impending switch to PoS and would like to see the network split in two, one for PoS and one for PoW.
If the PoW chain ever launches, all ETH holders will receive ETHPOW, the native token of the PoW chain, for free.
Researcher Ian Unsworth at Binance.US claims that customers are borrowing ETH using lending protocols, in particular AAVE.
CoinGecko’s Bobby Ong predicts that if current trends continue, the company’s already impressive usage rate of over 70% may reach 100%.
High usage will complicate liquidations
A high utilization rate indicates that most ETH has been borrowed, leaving insufficient collateral for liquidators to perform routine liquidations of ETH borrow-based positions.
According to Block Analytica’s recommendation, “high use interferes with liquidation transactions, therefore increasing the probability of insolvency for the protocol.
“Despite the positive reception the borrowing freeze has received, one crypto hedge fund partner, Ian Solot of Tagus Capital, noted that “the part of the problem is that if markets become very volatile and ETH borrowers need to be liquidated, there may be a scarcity of ETH due to high utilization, making it harder for liquidations to go through effectively.
“Forcible closing of positions as a result of a fall in the value of the collateral is known as a liquidation.
When the borrower’s health factor drops below 1 because the value of the collateral doesn’t equal the value of the loan or debt, liquidations are conducted, as described by Aave.
Recursive ETH trades lose appeal
There is a risk that the popular ETH-stETH recursive borrowing positions on Aave will become unprofitable if the utilization rate increases.
To add further uncertainty to the stETH market, this may cause investors to liquidate their holdings en masse.
In recursive transactions, users transfer ETH into Lido in exchange for the staked ether token (stETH), which they then deposit as collateral on Aave in order to borrow more ETH.
This new amount of ETH is then used to make another collateral deposit on AAVE in exchange for ETH, and the cycle repeats.
And so it goes; the cycle keeps turning. When the interest rate on borrowing ETH exceeds the annualized reward for staking ETH (3.9% currently on Lido), the carry trading-like leveraged position becomes unattractive.
According to the Aave ETHPOW risk mitigation plan announced last month, “after the ETH borrow rate exceeds 5%, which happens shortly after 70% usage rate, stETH/ETH trades start becoming unprofitable.
” With normal stETH holders transferring to ETH to get upside on ETHPoW work, this would put more downward pressure on the stETH price.
“All of these can lead to a downward price spiral of stETH, which can generate cascading liquidations at Aave,” Block Analitica said stETH is used as collateral by the largest ETH borrower on AAVE, and by the two largest ETH borrowers on AAVE, as per data tweeted by Binance.
USA’s Unsworth. As of this writing, AAVE has more than $900 million worth of stETH secured as collateral for ETH loans.
Aave is also vulnerable to liquidity providers withdrawing coins from wrapped ether (wETH) in preparation for the possible ETH fork currency ETHPOW.
There is some debate throughout the community as to whether or not temporarily halting ETH borrowing would be an effective solution to this possible issue.