AAVE Stops Loaning ETH Ahead of Merge

AAVE suspends ETH borrowing as the risk of high utilization leading up to the Merge could affect ETH liquidity.

The DeFi protocol’s community voted between Aug. 30, 2022, and Sep. 2, 2022, to pause ETH lending to protect the protocol from risks associated with excessive borrowing. According to research firm Block Analitica, suspending loans will prevent most of the ETH funds in AAVE’s lending pool from being loaned out, as people hoping to receive free tokens from a new ETHPOW fork before the upcoming Merge look to bolster the ETH balances.

Talk of a new Ethereum fork began in late July 2022, as the date of the so-called Merge drew closer. A fork is a permanent blockchain split when some members of a blockchain community disagree regarding the blockchain’s future and want to define a new set of rules for its future operation. Sometimes a fork results in a new token being issued.

The motive for the fork is to help miners keep their jobs after the Merge. The Merge will change the consensus mechanism of the Ethereum network from proof-of-work to proof-of-stake, meaning that the “miners” who validate transactions in a proof-of-work system would be replaced by “stakers.”

This change is bad news for miners, as it would render nearly $5 billion worth of graphics cards and special mining computers called ASICs worthless unless they could be repurposed.

A small cohort of developers has been working on a fork of the current Ethereum blockchain that would preserve the proof-of-work consensus mechanism, helping miners still use their expensive equipment.

Users are stocking up on ETH to receive free forked tokens

The lead miner who assembled the development team has said that current holders of ETH will receive free tokens from the proof-of-work fork called ETHPOW. A snapshot of all wallets holding ETH will be taken before the new tokens are distributed.

Consequently, many users are borrowing ETH from AAVE, resulting in a utilization rate of over 70%, meaning that most of AAVE’s ETH have been lent out. This high utilization means that little ETH is available to liquidate collateral should an AAVE borrower fail to maintain a certain debt-to-value ratio, creating insolvency problems for the protocol. Users get liquidated when their collateral value dips below the amount borrowed from AAVE.

Many users have deposited ETH into Lido to obtain another token, staked eth. They are then locking up the staked eth as collateral in AAVE to borrow ETH to again deposit into Lido, and the process repeats itself. This recursive process eventually becomes unattractive when the ETH borrowing rate on AAVE goes above the rewards offered by Lido for staking ETH. The unprofitability could result in users converting their staked ETH to ETH, putting downward pressure on the price of stETH. This selloff would add to the pressure of people converting stETH to ETH to receive free ETHPOW.

Remove ETH from liquidity pools

Bobby Ong, the co-founder of Coingecko, advised those hoping to receive free ETHPOW to ensure that their ETH is not on Optimism, Arbitrum, or any of the other Ethereum layer two protocols but is moved to the Ethereum mainnet. Also, he advised users to unwrap all wrapped ETH and to remove ETH liquidity from liquidity pools.

Binance suspended ETH transactions on Arbitrum, Optimism, and the Ronin sidechain until the Merge is complete.

There has been no word from a fellow lender and AAVE rival Compound Finance regarding the suspension of ETH withdrawals.

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