Until April 17, lending stablecoins on Aave yielded 2.32% APY, despite the Federal Reserve's overnight rate being 3.64%, implying the market viewed DeFi as a lower credit risk than the US Treasury. However, this mispricing ended abruptly. The market repriced DeFi credit risk in real-time, as the hierarchy of dollar-credit options by yield no longer made sense. Luca Prosperi had argued that DeFi stablecoin rates should carry a 250-400 basis-point premium over the risk-free rate, while the Bank of Canada cited Aave's 0.00% non-performing loan rate as proof of DeFi's defaultless lending.
The exploitation of Kelp DAO's LayerZero-powered cross-chain bridge led to the minting of unbacked rsETH tokens, which were used as collateral on Aave, resulting in a shortfall. This incident highlighted the contagion risk in DeFi protocols, as $6-10 billion in net outflows left Aave, and utilization on WETH, USDT, and USDC pools hit 100%.
Rates responded accordingly, with Aave stablecoin deposit APYs rising from 3-6% to 13.4% within two days. The lack of bankruptcy law and recourse in DeFi protocols means that there is no process for recovery, and the distribution of losses is unpredictable. This has direct consequences for risk sizing, and institutional allocators should take the signal seriously, recognizing that the 2.32% Aave APR prior to the incident did not reflect the underlying risk.