Lending Market Has Been Frozen Since November 2022 But Limited Liquidity For 0x Protocol’s Governance Token Could Result In Bad Debt If ZRX Drops Sharply
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.
Any potential bad debt isn’t likely to sink Aave — the safety module holds $235M of staked AAVE. The protocol also brings in annualized revenue of $17.2M, according to Token Terminal.
Ongoing Risk Mitigation
Aave governance froze the ZRX market last November after Avraham Eisenberg, an infamous proponent of ‘highly profitable trading strategies,’ left the protocol with $1.6M in bad debt. As such, the ZRX market isn’t visible on Aave V2’s interface, though it is visible on-chain.
A frozen market means users can neither borrow nor deposit a given asset, according to Aave’s documentation. Only loan repayments are allowed.
If ZRX drops to roughly $0.137, the position will be eligible for liquidation, according to a Snapshot vote from last month that increased the liquidation threshold of ZRX to 39% from 45%.
The borrower has been making regular repayments — the most recent one being $110,000 two days ago. Three other repayments totalling $360,000, were also made this month.
The address made its first deposit of 12M ZRX, worth over $6M at the time, to Aave V2 on Jan. 22, 2022, according to a query from Transpose, a company which provides blockchain analytics.
The wallet holds nearly 98% of the collateralized ZRX on Aave, according to Etherscan.
The 47.1M ZRX tokens would represent the sixth largest amount held by one wallet, according to Etherscan — however, the block explorer aggregates all collateralized ZRX tokens, called aZRX, into a single block of 47.6M tokens.
Aave and 0x declined to comment when The Defiant asked representatives of the projects about the collateralized position.
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