Aave Bitcoin Plan Could Expose WBTC Suppliers to Losses

Aave and Babylon Labs have proposed a native Bitcoin lending market that would keep collateral on the Bitcoin network while using wrapped Bitcoin (WBTC) to settle liquidations. The design was outlined in an Oct. 14 request for comments.

Borrowers would lock BTC in individual Taproot vaults. Aave would represent each vault on Ethereum with a restricted accounting token that users could not transfer freely.

When a position becomes eligible for liquidation, an outside liquidator would repay the borrower’s debt through an integration adapter. The seized vault would then be sold to the BTC Vault Swap Spoke, which would borrow WBTC from an Aave liquidity pool, known as a Hub, and pay the liquidator at an oracle-based price minus a discount.

The liquidator would receive a transferable asset immediately. The Swap Spoke would hold the Bitcoin vault in escrow and accrue interest on the WBTC loan. A permissioned arbitrageur could later acquire the vault by repaying the WBTC loan and interest, then redeeming the BTC on the Bitcoin network. The redemption would take several days because of a challenge window.

If the vault’s value did not cover the Hub’s WBTC debt, an arbitrageur could still buy it for an amount capped by the vault’s value after a reserved margin. The unpaid balance would be recorded as a deficit for the Hub in the same transaction.

Aave’s deficit framework assigns losses to suppliers of the asset borrowed by the relevant Spoke unless another protection mechanism covers them. DAO-funded offsets can take the first loss in some cases, followed by Umbrella protection where configured. The initial recommendations cover WETH, USDC and USDT markets. The proposed WBTC financing is outside that scope, and the proposal does not specify a funded WBTC backstop.

The Hub’s final funding arrangements, borrowing limits and any dedicated protection would be set in a later risk-allocation process. Without protection, a shortfall from the Swap Spoke’s WBTC loan could reduce the value of WBTC suppliers’ positions.

The proposal also includes a direct route for authorized application keepers. A keeper could repay a borrower’s debt, start redemption of the Bitcoin to its own key and finance the settlement period without borrowing WBTC through the Swap Spoke. This route would limit participation to operators able to fund the repayment and claim the Bitcoin.

Permissionless liquidations could fail if the Hub lacks enough WBTC or if the Swap Spoke has insufficient borrowing allowance. Registered arbitrageurs could still use the direct redemption route.

Aave DAO would govern the proposed Spokes and their funding Hubs. A separate 2-of-3 multisignature group made up of LlamaRisk, Babylon Labs and Aave Labs would configure the Swap Spoke. Babylon’s protocol governance would manage its settings and authorized actors through a public timelock.

The request for comments lists community feedback, a conditional Snapshot vote and a later on-chain proposal with full risk parameters as the next stages. Babylon’s documentation says five components have undergone audits, while Coinspect, ABDK and Zellic are reviewing finalized changes before a possible mainnet deployment.