Why Aave's Unified Pool Turned a Bridge Hack Into $193M in Bad Debt

Transcript

Yeah, I'd say um there's certainly some fault to be shared across the board here. You know, Kelp with over a billion and client deposits um c can do better than a one of one and certainly we know at this point a one of one is pretty frowned upon. Um then of course layer zero uh who had their their off-chain RPC infrastructure compromised um perhaps they shouldn't allow the 101 to be the out ofthebox kit um for new deployers on the OFT standard and perhaps push back more um I think the numbers show close to 40% of those unique OFT deployments are on that that

one of one um >> really so you're saying that 40% of people that use this infrastructure still have that one of one >> not not of total capital but of um of unique OFT deployments and a number have since been upgraded as well uh following the exploit and >> hopefully we we we saw a lot of um unique uh asset issuers who run the layer zero OFD they had to freeze their infrastructure as well to evaluate any any compromises on their end and then third downstream um for a when listing the the RS as collateral. Um perhaps of course that the one of one uh signer on the O of

deployment um that could have been flag flagged as a risk for the collateral listing and parameters adjusted accordingly um for that. Yeah, you would think. I mean, I know we're going to I think in this conversation we'll get to things like like circuit breakers or rate limiting. Um but uh yeah, all those things um certainly could have could have helped. Um so Shandra, back back to you. Um want to focus on on a and there's different levels of um I guess knowledge about how these DeFi platforms operate. I mean to a certain baseline like how they function, but then also how they're used. Uh and your report does break out um some delineations. I mean a um sort of their implementation on on mainet a version three which is

which is the main pool the bluechip pool that sort of like co-mingles all all deposits and that's part of what makes it a very powerful um platform for for Dar participants to use but then it also um kind of socialized this risk that um the extent of which was was unknown. Uh I'd love for you to just explain the design choices that went into that but uh yeah let's just start with that. I mean, why did they choose that setup? And then I have a followup. >> Sure. So, this kind of ties into um modular versus monolithic lending. And it also ties into a very interesting point that we made about looping and its impact on the severity of the attack.

So, with protocols like this, you have two sides, right? You have the lenders that are supplying their collateral, and that gives them borrow power to allow them to borrow assets against that collateral. But in this collateral pool, assets are all pulled together and there's no distinction between what assets are allowed to be borrowed against it or the different rates of interest rate. So normally under a lending setup, you would expect if I were to deposit ETH in the protocol, you expect a very diverse set of lenders using different collateral at different loan to value ratios to borrow against that. Right? I might have one fund that has deposited Bitcoin borrowing my ETH um some users depositing stable coins.

But when we look at the actual user behavior on these lending platforms and we think why would someone borrow ET as an asset there's only one real reason which is to go short that asset right to borrow it and then sell it on the market. So we don't really see much organic behavior borrowing E. We saw we see a lot of people using it as collateral depositing to borrow USDC but we don't really see much organic borrow demand. And an example we can give here is um rap BTC which is another market um that has a utilization rate of only around 4.8% at the moment and it's extremely cheap to borrow around 40 basis points per year. What we're seeing instead, the type of behavior is people taking these poolled reserves, right?

Because ETH can be borrowed and there's no distinction between what collateral types are used. And we see a lot of leverage looping, which is the activity of a user using an active state version of ETH that generates yield to borrow a passive wrapped ETH version of it, converting that back into the active asset that generates yield and looping that back and forth. Uh so that is basically the primarily use case of using this wrapped ETH in the pool reserves. And when we looked a little bit deeper, we saw that around 98% of collateral backing these positions uh wrapped ET that was borrowed was in these LSTs.

>> Yeah. Yeah. It's it's interesting. I mean the looping idea, it's something I've been familiar with for years. anyone who actively follows crypto is is aware of because uh uh it's just a very simple way to to get leverage and when things are are going well and that the numbers add up it's it's a sort of a a market neutral way of of juicing returns but it can be dangerous. I mean it for I mean for one thing uh I don't again I don't know how much people understand the way these markets work but just because when you borrow money u my understanding from a platform like a you borrow at a certain interest rate but it's not fixed um it's variable and and it can change people can get caught on the wrong side of it and then it leads to um rapid deleveraging and and real

problems getting out of these leverage positions but then also I I wonder too I mean this looping um do you think it constitutes any real economic activity or is it just a way of getting excess as excess leverage and um to what extent does that sort of just um what's the word I'm looking for like warp like incentives and and sort of risk risk guard rails I mean I guess it would depend on your definition of real economic real economic activity I would say it is real economic activity right because without this looping demand it would have no utilization the loop ing traders are borrowing ETH which increases the

utilization. It also increases the interest rate for the lenders. So when you deposit Eid onto the platform I think you would have historically earned around 1.7% APY versus the example of Bitcoin that I gave where you earn 0.01 because no one's borrowing it. So it is generating economic activity a lot of demand a lot of use from lending platforms is this looping. Um the question is just does that kind of obscure the risk that you're taking on as a lender when you believe you're depositing into this diversified pool when in reality 98% of it is just running this trade.

>> But I would say that it does constitute real activity. >> Fair enough. And I know in your report you also pointed out that um the majority of of the the the wrapped ETH debtors are concentrated in like the top 10. Um, do you have any sense of of who those those people are? Um, and and I guess like yeah, do you know who they are? >> Yeah, so we we did take those wallets and we just ran them through Arkham to see what they were labeled as. And these wallets are essentially vaults, right? If you think about what leverage looping is, you could do it manually where you take the LST, borrow E, convert that into LST and and do that loop again. But a lot of people are just doing this

automatically through vault programs. So for example, the top um wallet is Etherfy's vault product. Right. So that basically just abstracts all the looping in the background and you basically presented to the user as high yield ETH product. >> Mhm. Okay. And um I am curious too. I mean before we move on to um to Luke uh you did contrast like this setup with with Morpho which which is a bit more a bit more segmented. Can you uh maybe expand on that a little bit more and um sort of think about design choices that might impact the way DeFi looks in the future?

>> Yeah, exactly. I think we'll get a little bit more into this in the end, but the meat of it is that you have a poolled option which is a where each asset can be borrowed and you're not choosing what assets you can be lent again. Right? So if I'm depositing ETH in the pool, any user with a health factor who has deposited collateral can borrow that ETH. Uh I cannot say for example, I'm not comfortable with a looper borrowing my ETH. I want to make that available only to someone with BTC or USDC. On more full, you have this extra layer of customizability where you are able to choose what assets are allowed to borrow your collateral. But the reason that we saw this do so well

on A versus Morful, like the looping chair has been very concentrated on a is just because when you have this one risk parameter that's shared to the entire pool, you're essentially forcing each ETH lender to opt into the system and now you have billions of dollars of ETH TVL that's compounded over the years and the risk team has just made that available to be borrowed at a low interest rate for Lubers, right? So you have a lot more liquidity and lower interest rates on a which is why the trade has just um flourished over