Recently, cryptocurrency prices have returned to levels last seen in February during the market drop. In their aftermath, the number of liquidations on lending protocols has dropped significantly.
This is not a coincidence. This event can be seen, in practical terms, as a (very) brief borrowing opportunity. At the same time, it is clear that we are not in a liquidation-free zone. Thus, participants in the decentralized finance (DeFi) space are being appropriately, if not overly, cautious.
Aave, one of the most significant lending platforms, has experienced a steep decline in high-risk loans on its Mainnet. The total value of high-risk loans on Aave has dropped by almost $1 billion since the large liquidation event earlier this year. The decrease is partly due to liquidations that were forced, but a larger part of it seems to have been prompted by a change in the broad market sentiment. That sentiment is now much more conservative, especially among the larger borrowers who had been maintaining a pooling fund strategy. These borrowers seem to have shifted to a more low-key approach, perhaps due to ongoing uncertainty about price movements.
The Deleveraging Trend: Why Investors Are Becoming More Cautious
Historically, using leverage in DeFi lending protocols was a common way for investors to try and boost their returns when the market was going up. They would borrow against their crypto holdings and use the proceeds to invest in even more crypto, with the thinking being that the rising prices would push their net worth far above what they would have had if they hadn’t taken on so much debt. Right now, though, the large deleveraging we’re seeing isn’t about return compression. It’s a panic move driven by the fear that crypto prices are going to fall much further from where they are now.
This watchful sentiment is for the most part spurred by the still bearish trend in the crypto market. The February price drop had already set off a good bit of correction in prices, but as some player speculate, it could just be a quiet part of the storm before things get really crazy again. That’s because ongoing uncertainty about a number of macroeconomic factors, regulatory concerns, and just general confidence in the broader financial markets has a lot of people on edge—and watchful for any further price drops.
This wider trend of deleveraging is also evident on lending platforms such as Aave, where the amount of high-risk loans has dropped significantly. Instead of keeping large, precarious loan positions that could lead to forced liquidations down the road if the market takes another downturn, lots of would-be borrowers seem to have gotten the memo and are keeping things low-key and conservative.
Even though the market continues to see forces of nature that compound downside pressure (including rising interest rates and a strengthening dollar, among others), these forced liquidations haven’t been nearly as dramatic as in past downturns.
Meanwhile, both the overall crypto market and Bitcoin specifically have rallied hard over the past few weeks. As of this writing, BTC is back up over $50K and almost all altcoins have retraced in a big way, with some actually hitting all-time highs again!
The Impact on DeFi Lending Platforms
High-risk loans on Aave Mainnet have decreased, and this isn’t just about individual investors making different choices. It’s also about some larger trends in DeFi. We think these trends are positive for DeFi lending protocols and for Aave. What we see happening in Aave Mainnet is happening in other DeFi protocols as well. DeFi lending protocols are becoming more sophisticated and offering borrowers and lenders more tools to manage their positions and risk exposure.
This trend might carry several consequences for DeFi lending platforms. It could suggest that the market is maturing, with participants now aware of the risks and making smarter, more strategic decisions about what kinds of loans to take out. DeFi lending was supposed to be all upside, but apparently not everyone sees it that way anymore. On the other hand, this trend could also be an indication that growth in the DeFi lending sector is slowing down.
The reduction in liquidations could be a positive sign for the stability of DeFi platforms, as it suggests that people are borrowing and not getting margin called. It could also mean that we are not in a liquidity crunch and that DeFi is not suffering under the kinds of conditions that create downward price spirals. Overall, it could be construed as a positive development.
Looking Ahead: Will Caution Prevail in the Long Run?
Liquidations are down, and investor behavior has changed markedly in DeFi lending protocols. Where there used to be a “more-borrowing-must-equal-more-risk” top-down approach, there now seems to be a systemic shift toward more-rational-risk models. In the short run, this should help provide some much-needed stability to the DeFi lending market and to investors. But in the long run? Who knows. If the DeFi market continues to feel bearish for much longer, it seems almost inevitable that investor behavior will also feel the weight of further downside impacts and that we will see no further spikes in risk-taking on the part of loans.
Simultaneously, if the market starts to settle or show recovery signs, investors may pour in with new confidence, potentially leading to an increase in borrowing and a rise in leveraged positions. But for the time being, the market’s overall tone is one of caution, with many of its participants acting to trim not-incrementally-revised exposures.
In the end, how well the DeFi market can withstand any future downturns will come down to what individual investors do and the larger market ecosystem. With so much uncertainty, DeFi borrowers seem likely to maintain a distinctly unfriendly posture toward any future margin calls, which should help keep liquidation events at lower levels. Their deleveraging in the space and liquidation events seen thus far reflect the appearance of a contrarian safe harbor for investors not using the lending-and-borrowing facilities of DeFi.
Disclosure: This is not trading or investment advice. Always do your research before buying any cryptocurrency or investing in any services.
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