A new study from the Bank of Canada scrutinized Aave V3's lending model, revealing a clear trade-off between lender safety and borrower risk. Analyzing data from Jan. 27, 2023, to May 6, 2025, the paper confirmed that automated liquidations and overcollateralization kept non-performing loans at zero throughout 2024, even during volatile crypto markets.
Lender protection via automatic triggers
The report explains that Aave V3 requires borrowers to post collateral exceeding their loan value. Once a position becomes undercollateralized, the system automatically closes it — often before the collateral falls below the outstanding debt. This mechanism shielded lenders from any credit loss, but the Bank of Canada noted the system relies solely on code, not credit checks.
Borrowers bear hidden costs
Risk shifted to borrowers. The central bank calculated liquidation fees ranging from 5% to 10%. Combined with missed gains from price recoveries post-liquidation, total borrower losses hit 10% to 30%. In other words, even if the market later bounces, liquidated users cannot participate in the upside.
Concentrated liquidation waves
Liquidations were not evenly distributed. Wrapped Ether, Wrapped Staked Ether, Wrapped Bitcoin, and Wrapped eETH accounted for about 90% of the total liquidated value. This concentration means sharp price drops in major cryptocurrencies trigger rapid, clustered liquidations, amplifying systemic risk.
Recursive leverage: over 20% of borrow volume
The study highlighted recursive leverage, where users repeatedly borrow against the same collateral to amplify exposure. This strategy represented over 20% of total borrow volume and 8.2% of all borrowing transactions. While boosting activity, it also made the protocol more vulnerable during downturns as leveraged positions quickly approached liquidation thresholds.
As the findings land, Aave V4 has already launched with a redesigned architecture. According to the report, the new version aims to separate liquidity and risk across markets while offering more flexible borrowing terms. The Canadian central bank's analysis serves as a timely reference for how DeFi protocols can balance efficiency and safety.