Until April 17, the market was willing to lend stablecoins into Aave at a 2.32% APY, despite the Federal Reserve's overnight rate being 3.64%. This implied that the market viewed an unregulated, open-source smart contract as a lower credit risk than the United States Treasury. However, this mispricing was short-lived, as the market rapidly adjusted its valuation of DeFi credit risk over the following 48 hours. The catalyst for this change was an exploit on Kelp DAO's cross-chain bridge, which allowed an attacker to mint unbacked tokens and borrow against them on Aave.
The subsequent collapse of Aave's credit market led to a cascade of failures throughout the DeFi ecosystem, with utilization on major pools reaching 100% and depositors unable to withdraw their funds. As a result, rates skyrocketed, with Aave's stablecoin deposit APYs surging to 13.4% and Morpho's USDC vault jumping to 10.81% APR. The lack of bankruptcy law and recourse within DeFi protocols means that users who withdraw first can keep everything, while those who are last in line may absorb a disproportionate share of the losses.
This has significant implications for risk sizing, as the total loss can be estimated, but the distribution of that loss is uncertain. Ultimately, the events of last weekend serve as a reminder that DeFi is not risk-free and will always carry a premium over its regulated equivalents.
Institutional allocators should take this signal seriously when sizing their DeFi exposure for the coming year.