Bank of Canada Study: Aave V3 Avoided Bad Debt — But Borrowers Paid the Price

Zero Defaults in Over Two Years

The Bank of Canada has published a research paper examining the lending mechanics of DeFi protocol Aave V3. The core finding: between January 27, 2023, and May 6, 2025, the platform recorded zero instances of bad debt. This outcome stems from Aave's overcollateralization model and automated liquidation mechanism — smart contracts close positions before collateral values fall below outstanding loan amounts, effectively shielding lenders from losses.

Why This Matters

A central bank from a G7 nation conducting in-depth analysis of DeFi lending protocols marks a notable shift in institutional and regulatory attention toward decentralized finance. The researchers explicitly acknowledged that intermediary-free lending is technically and operationally viable. At the same time, the study's identification of concentrated risks, cascading liquidations, and regulatory gaps establishes a clear agenda for ongoing discussions about DeFi's future within the broader financial system.

Borrowers Bear the Burden

The flip side of robust lender protection is substantial losses for those who borrow. Bank of Canada analysts found that during sharp market downturns, liquidations execute rapidly and frequently at unfavorable prices. Liquidation fees alone average 5–10% of the closed position's value. When factoring in missed gains from subsequent price recoveries, actual borrower losses reach 10–30%.

Liquidation events are not evenly distributed — they occur in waves that amplify downward market pressure. Roughly 90% of all liquidated positions involve just four tokens, all of which are "wrapped" versions of Ethereum and Bitcoin. This concentration creates heavy dependence on the price trajectories of the two largest crypto assets.

Recursive Borrowing as a Vulnerability

An additional systemic risk factor identified in the study is recursive borrowing — a strategy where users repeatedly pledge borrowed assets as collateral to amplify their loan exposure. According to the research, this form of leverage accounted for over 20% of total borrowing volume in 2024. The problem: recursive positions are extremely sensitive to price declines, accelerating cascading liquidations and magnifying borrower losses during market shocks.

DeFi Lending: Viable but Limited

Bank of Canada researchers concluded that decentralized lending is technically viable — smart contracts effectively manage liquidity distribution and maintain system stability without traditional intermediaries.

However, the study highlighted several critical limitations:

• Fragmented liquidity pools result in underutilized capital, reducing overall protocol efficiency.
• The overcollateralization requirement makes borrowing expensive and limits DeFi's applicability beyond crypto-native use cases.
• The system does not eliminate risk — it redistributes it, primarily onto borrowers.
• The absence of clear regulatory frameworks and traditional lending safeguards such as capital requirements, leverage limits, and liquidity thresholds remains a fundamental concern.

For context, Aave's development team launched the protocol's fourth version (V4) on the Ethereum mainnet in March 2026.