Aave V3's Risk Management Model Analyzed in Bank of Canada Study

A recent staff paper from the Bank of Canada has highlighted the effectiveness of Aave V3's risk management model, which reported zero non-performing loans in 2024. According to Cointelegraph, the study attributes this success to the platform's overcollateralization and automated liquidation processes, which have been instrumental in preventing lender losses within its Ethereum lending market. The research utilized transaction-level data spanning from January 27, 2023, to May 6, 2025, revealing that positions were typically liquidated before collateral values fell below the outstanding debt, thereby containing lender losses across the sample period. However, the paper notes a tradeoff in Aave V3's model. While it effectively shields lenders from unrecovered losses, it shifts risk onto borrowers and limits capital efficiency compared to traditional lending systems. The design of Aave V3 relies on automated risk controls rather than conventional underwriting, requiring borrowers to post more collateral than they borrow and liquidating positions when risk thresholds are breached. The study also found that Aave V3's lending activity was not solely driven by liquidity needs. Recursive leverage, which involves repeatedly borrowing against collateral and redeploying borrowed assets as new collateral, accounted for over 20% of the total borrowed volume and 8.2% of borrowing transactions during the sample period. The paper highlights that this dynamic exposes borrowers to increased risk during market downturns. Liquidations on Aave V3 were observed to occur in concentrated waves, with four assets—Wrapped Ether (WETH), Wrapped Staked Ether (wstETH), Wrapped Bitcoin (WBTC), and Wrapped eETH (weETH)—accounting for 90% of the total liquidated value. The study estimates that borrower losses during major liquidation events could be substantial, with liquidation fees typically ranging from 5% to 10% of the liquidated value. Additionally, missed gains from subsequent price recoveries could push combined losses to about 10% to 30% in some cases. The paper concludes that while Aave V3's design helps prevent unrecovered bad debt, it does so by exposing borrowers to abrupt losses when collateral prices fall sharply. Cointelegraph reached out to Aave for comment but did not receive a response before publication.