(Bloomberg) — Decentralized finance is in the midst of the largest coordinated rescue in its history, an effort marked by moral hazard concerns and ad-hoc coordination that sit awkwardly with the sector’s founding pitch as a disruptor of traditional finance.
A week after a security breach at a small crypto protocol called KelpDAO triggered a $10 billion run on Aave, the largest DeFi lending protocol, the platform’s founder and a coalition of allied crypto projects are working to restore liquidity. Their goal is to let users withdraw funds and unwind positions.
So far, the group has committed Ether tokens worth about $240 million to restore the backing of rsETH — a token meant to represent staked Ether, which sat at the center of the hack — and make Aave depositors whole. The contributions, some in the form of loans or credit lines, would go a long way toward covering the shortfall created by the exploit.
Interest rates that spiked in the wake of the KelpDAO exploit have eased over the past two days, an early sign that liquidity strains are diminishing. Even so, fresh deposits have yet to return to the platform in any meaningful way, based on data from Aavescan.
The chain of events that strained Aave has raised questions about interconnected risks in DeFi, a $130 billion corner of crypto where investors trade, borrow and lend digital assets over protocols that run on highly automated code with minimal human intervention.
The rescue effort, in turn, has sparked hand-wringing among those who fear it could perpetuate risky behavior, while violating the decentralized principles the sector was built on.
Many of the positions under stress at Aave were built using so-called looping strategies, where users repeatedly borrow and redeposit to amplify returns. In normal conditions, the system manages that risk through collateral and liquidations. In a liquidity freeze, those safeguards stop working.
“Bailing out the market sets a precedent that those executing ‘looping’ strategies are not on the hook for loss event,” Monet Supply, the pseudonymous head of risk and strategy at DeFi lender Spark, said in an email. “This may cause these entities to risk-on further if they think the broader community will bail them out when things go wrong.”
Aave Labs frames the response differently.
“The DeFi ecosystem have come together – multiple networks and protocols and others, including individuals – to support users,” a spokesperson said. “What we’re seeing is participants across DeFi coordinating to restore backing and maintain confidence in onchain markets. Protecting users and preserving trust is fundamental.”
DeFi was pitched as a system that would render this kind of intervention largely unnecessary, one protected by the cold logic of smart contracts ensuring that all loans have surplus collateral and get liquidated when predetermined thresholds are met.
Framed that way, the episode risks denting the ideological image of the sector, which has marketed itself as a sort of anti-Wall Street where “code is law” and decentralization offers a built-in bulwark against the excesses that marked the global financial crisis.
“We can throw away the mirage of complete decentralization,” said Pratik Kala, a portfolio manager at Apollo Crypto. “This is exactly how a centralized institution would behave.”
How Hackers Used Aave
Aave’s own smart contracts were not compromised. The protocol, as designed, accepted rsETH as collateral, assuming — like every other platform holding it — that each token was backed one-for-one by underlying Ether.
An event far outside its control that touched off the crisis. Hackers widely thought to be affiliated with North Korea drained almost $300 million worth of digital assets from a protocol known as a crypto bridge operated by KelpDAO. Then, in a novel twist, they deposited most of the loot onto Aave as collateral for borrowing — a move that, once it became public, triggered doubts about the backing of assets across the system and sent depositors fleeing.
The coalition to prop up Aave, named DeFi United, has received commitments for funding from outfits including AaveDAO and Mantle, a network backed by the Bybit crypto exchange. Stani Kulechov, Aave’s founder, is also contributing funds.
DeFi protocols like Aave bear more similarities with peer-to-peer lending platforms than with traditional banking, although there are some key differences. And even though total assets on Aave are less than 1% of those at JPMorgan Chase & Co., its outsize role within DeFi meant its troubles quickly spread across the sector.
Aave accounts for roughly 60% of the DeFi lending market, according to Token Terminal. Its interest rates, collateral thresholds, and pricing feeds are embedded across dozens of other protocols.
That meant other platforms got hit as well, even ones that didn’t have direct exposure to the cryptoassets the hackers stole.
Total value locked — the industry’s main gauge for measuring assets — across other DeFi protocols plunged by as much as $16 billion in the wake of the Aave incident, with projects like Morpho and Mantle suffering big outflows, data from DefiLlama show. Aave is the dominant lending protocol on the Mantle blockchain, accounting for over half of its TVL.
“Had there been no bailout, losses would’ve been socialized across depositors, triggering a far bigger run than the $10 billion we’ve see so far,” Rajiv Sawhney, head of international portfolio management at Waves Digital Assets said.
The fallout went far beyond DeFi lending, with various projects with links to Aave getting disrupted.
With the fate of the proposed rescue partially hinging on the price of Ether, Aave and its backers are in a race against time. Should the effort fail to restore confidence, the risk is that outflows from DeFi resume, destabilizing other projects.
“The rush is to stop the contagion from spreading, especially in case of a crypto market downturn at this stage,” Apollo Crypto’s Kala said. “If Ether drops 10% to 15%, this gets much worse very quickly. A lot of positions would just get wiped out.”
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