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As liquidity across DeFi 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 that has an outstanding loan of $2.5M 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 over $4.5B in total value locked. ZRX is the governance token of 0x Protocol, the developer of the popular Matcha DEX aggregator. Like most DeFi assets, it’s down more than 90% from its April 2021 peak.
While 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 bumped up the liquidation threshold for ZRX as recently as August, a sudden drop in the price of ZRX has the potential to saddle Aave with 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.
Limited Liquidity
The ZRX token has limited on-chain liquidity — a sale of just 1M ZRX would result in a 60% loss in value due to slippage, according to Matcha, a DEX aggregator which spreads trades across all sources of liquidity to obtain the best pricing. Even a partial liquidation would likely require more than 1M ZRX to be sold – the borrower holds over 47M ZRX.
And while ZRX is listed on centralized exchanges like Binance, there is limited liquidity available there as well, according to Coingecko.
The low liquidity means that 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 position on Aave, one must pay back the borrowed asset in exchange for receiving the defaulted collateral at a discount. Liquidators typically sell the seized collateral immediately 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.
In this case, the low liquidity would make liquidating the position unprofitable — 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.
In cases of 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 incentivized to stake their tokens in the Safety Module to earn rewards in the form of more AAVE tokens.