Downstream Risk in Lending Markets: Isolated, Shared & Hybrid

Over the last few months, DeFi has seen several stark reminders of the risk present in lending markets. Even when a lending market isn’t directly exploited, collateral assets can become impaired and liquidation failure leaves downstream participants holding the bag. 

Two exploits highlight how far the impact can spread. The KelpDAO/LayerZero bridge hack drained $292M in rsETH, and the hackers used Aave V3 to borrow against the impaired collateral, leaving WETH lenders with no liquidity to exit. Resolv's $23M exploit depegged USR, which then flowed into Morpho markets and locked $7.77M in lender liquidity inside vaults that couldn't process withdrawals.

As DeFi becomes more interconnected, hackers have more ways to extract liquidity. Nexus Mutual’s Protocol Cover is designed to protect lenders from bad debt when oracles and liquidations fail across all the different lending protocol types. 

What Are Shared Lending Markets: Peer-to-Pool

Aave innovated the peer-to-pool model, turning it into the largest DeFi lending protocol. Suppliers deposit assets into shared liquidity pools on each network and earn yield when their assets are lent out. Borrowers take out loans by tapping into the liquidity from these shared pools, using any listed asset as collateral to borrow other approved assets. Yield is based on utilization and the parameters that risk service providers set.

The peer-to-pool model is designed to be capital efficient, with access to deep liquidity, competitive rates, and broad composability across DeFi. Using Aave's Efficiency Mode (E-Mode), borrowers working with correlated assets, like stablecoins or ETH derivatives, can unlock loan-to-value (LTV) ratios of up to 97%. 

Risk in Shared Lending Markets

With greater composability comes greater risk, so Aave addresses this with its own risk management features. For example, their “Isolation Mode” lets governance list new or volatile assets with a hard debt ceiling and restricted borrowing. However, even with limits and restrictions on collateral assets, edge cases can impact liquidity.

The KelpDAO/LayerZero attacker exploited the rsETH LayerZero bridge and deposited 89,567 stolen rsETH on Aave V3, borrowing 82,650 WETH and 821 wstETH to access liquidity. WETH lenders in those markets were exposed to impaired collateral with no available liquidity to exit in the aftermath of the exploit.

The market reaction was swift. $8.45 billion left Aave in 48 hours and total DeFi TVL dropped $13.4 billion in two days. The wider DeFi community quickly united to find a solution and plug the hole in rsETH’s backing, but the incident was a clear example of how risk can spread through a peer-to-pool lending market.

How Are Isolated Lending Markets Different?

Isolated markets take a different approach. Instead of one shared pool, each market is siloed. Morpho is the market leader for this model, and the Resolv incident shows how isolated markets can contain fallout.

Within Morpho Blue (a.k.a., Morpho Markets V1), each market is defined by a single collateral token, loan token, oracle contract, and set of risk parameters. Markets are permissionless and immutable once deployed. Risk is bounded by design: impaired collateral in one market has no path to the liquidity in another.

The Morpho Vaults protocol layer adds active management capabilities on top of the isolated structure in Morpho Blue. Vault curators like Gauntlet, Steakhouse Financial, and kpk allocate liquidity across multiple Morpho Blue Markets and can rebalance or withdraw available liquidity when a market shows signs of stress. 

When Resolv's depegged USR was deposited into the USR and wstUSR Morpho markets after the exploit, roughly $7.77 million in liquidity from lenders was locked inside markets that accepted USR, wstUSR, and RLP as collateral. While lenders in the impacted markets were unable to withdraw liquidity and were impacted by unrealized bad debt, the other Morpho markets kept running.

Hybrid Lending Markets

Hybrid lending markets are all focused on the same question: how do you keep risk contained while keeping capital productive?

Aave V4 introduces hub-and-spoke architecture that looks to build off both models' strengths. A central hub coordinates liquidity, accounting, and interest rates across all assets. Spokes are modular units, each handling supply and borrowing logic for a specific asset or asset class, while routing liquidity to and from the hub. As markets evolve, new spokes can be added without migrating existing liquidity.

The risk model has been redesigned as well. In Aave V3, risk parameters apply uniformly across all borrowers of a given asset. In V4, each borrower's rate adjusts based on the quality of their specific collateral. Borrowers posting ETH pay a lower risk premium. Riskier assets attract higher borrowing costs. 

Euler V2 offers another hybrid model. Curators can create simple isolated collateral-debt pairs on Euler, as well as clusters of vaults with shared exposure across assets in one market. The Ethereum Vault Connector enables this by linking vaults together, letting borrowers use collateral in one vault to borrow from another.

However, Euler V2's hybrid design didn't fully insulate it from the Stream Finance fallout last year. When Stream Finance was exploited for $93M in November, Euler V2 suffered downstream impact alongside Rings, Beefy, and Harvest vaults. Nexus Mutual paid over $98,000 in claims to members across all four protocols. 

Covering Lending Market Risk

No lending market model fully eliminates the risk of liquidation failure or bad debt. 

Nexus Mutual’s Protocol Cover is specifically designed to protect against these events with our liquidation failure clause, which is defined an event where:

• Keepers (i.e., the entities running bots that perform liquidations) are unable to liquidate collateral backing unhealthy borrow positions, resulting in bad debt that is subsequently socialized and passed on to all lenders within the affected market; or

• Keepers liquidate collateral backing unhealthy borrow positions for an amount less than 80% of the fair realisable market value of the collateral, taking account of the prevailing market conditions.

Nexus Mutual offers Aave V3, Blue Chip Morpho Vaults & Markets as well as Blue Chip Euler V2 Vaults & Markets Protocol Cover. 

If you hold positions in a covered protocol and want to understand what you can be protected against, reach out to us at nexusmutual.io/contact.