Note: Not Financial Advice
‘Rehypothecation’ refers to the practice of a lending organization re-using assets posted as collateral by their own customers. Usually, this takes the form of lending these assets to different lenders, who then post collateral to secure their own loans, and so-on. Depending upon the quality of the collateral posted and the loans secured however, this has the potential to cause financial contagion through associated risks.
On AAVE, this process is mandatory. This is because the platform’s smart contracts do not lend out AAVE’s own assets, but only facilitate users trustlessly interacting with each other’s assets - whether lending or borrowing them.
On 22nd November, Avraham Eisenberg put into practice his theorized attack that Arkham previously covered, as he built up a position that would be worth at peak around $50 million, with over $100 million of combined collateral and debt positions.
The address 0x57e is not only listed as part of the FortressDAO multisig (an infamous project allegedly held hostage by Eisenberg himself), but is also funded by ponzishorter.eth, a well-known Eisenberg address. He has also theorized a similar attack in the past, with Tweets made approximately one month prior to this writing.
The core of Eisenberg’s on-chain position was centered around injecting USDC collateral to a leveraged CRV borrow on AAVE. This strategy involved depositing USDC onto AAVE, then looping (rehypothecating) his own deposit by borrowing CRV, selling it on the open market and then depositing more USDC to AAVE.
The total inflows to the address were ~55.5 million USDC, from Eisenberg’s address ponzishorter.eth and Circle. The total outflow from the address was ~71.5 million CRV tokens, all sent to OKX. It is difficult to tell whether those tokens were immediately liquidated or held for a profit after the strategy executed.
The position was, at its peak, a borrow of 92 million CRV tokens, collateralized by approximately 60 million USD from looped borrow transactions. This placed extensive strain on the AAVE market for CRV, with Eisenberg making up 63% of the total CRV Borrow at the time of the first Arkham publication on this topic.
Initially, observers interpreted the position as an attempt to push CRV prices sufficiently low enough to liquidate a prominent Curve Team-owned CRV long position, with liquidation at $0.269 per CRV. However, this wrongly assumed that Eisenberg was directionally exposed to the short side, with no hedging and a significant liquidation price publicly telegraphed on-chain at $0.62.
This liquidation, however, could have had potentially serious consequences for AAVE if it was not managed properly, given there was only enough liquidity available on-chain to close out approximately 20% of the position.
The extensively-looped and highly-levered AAVE position posed the risk of possibly bringing the platform into bad debt if the USDC collateral was liquidated all at once, given the price of CRV could have risen too quickly to allow liquidation bots to close out the entire position before the value of Eisenberg’s account went negative.
It seemed that on the face of it, to liquidate Eisenberg’s position, AAVE liquidators would have had no way to buy back all the CRV Eisenberg borrowed without incurring significant slippage. This could have caused up to 8 figures of bad debt on the AAVE platform if CRV had reached a high enough price, possibly more.
Liquidity profiles are hard to analyze in face of a token with a low trading volume but high supply. In many ways, AAVE was at the mercy of CRV holders. Meaning, if CRV holders sold enough supply into the liquidity pools while Eisenberg’s position underwent liquidation, then AAVE would have been fine. But if not, then AAVE itself would have become saddled with millions of dollars of bad debt.
So how did the liquidation ultimately occur?
Eisenberg’s entire short position of 92 Million CRV tokens was eventually liquidated at a cost of $1.6M in CRV debt to AAVE. Meaning that, although AAVE allowed liquidators to sell off the entire amount of Eisenberg’s USDC collateral, the average price at which Eisenberg’s USDC was liquidated for CRV was ultimately higher than his collateral would provide for. Eisenberg’s loan went from overcollateralized to undercollateralized, at the expense of AAVE’s markets.
Arkham initially believed that Eisenberg’s short could produce ‘severe bad debt’ in AAVE’s system, so only needing $1.6M to pay off the excess was actually a great success for AAVE - and the team knew it.
The core problem was not with AAVE itself, but the liquidators' ability to source CRV. Liquidation bots attempting to acquire CRV through buying it on-market would have faced themselves with a lot of slippage, driving the price up and causing the remainder of the account to have been liquidated at a loss for AAVE. However, the slippage is not the liquidators' problem - it's AAVE's bad debt to bear.
Most liquidation transactions take place atomically. That is, the liquidator sources the CRV, exchanges the debt tokens, then receives the liquidated collateral, all in one bundle. There is a penalty to the liquidated party, paid to the liquidator - so it pays quite well to perform these transactions.
The real issue for AAVE was co-ordination, and it is very difficult to co-ordinate with a party whose code executes automatically. The screenshot shows numerous different liquidator bots selling Eisenberg’s collateral in chunks, with CRV mainly delivered from the largest on-chain source of CRV liquidity, the Curve CRV pool.
Certain liquidators attempted to "buy time" by actually liquidating Eisenberg with CRV tokens that they themselves borrowed from AAVE. This liquidator took on the debt, bought their liquidated USDC at a discount, and unwound the position when the drama had subsided.
However, even this was not enough to fully liquidate Eisenberg’s CRV short. The price of CRV in the pool needed to be kept low enough to prevent liquidation on unfavorable terms. Millions of dollars of CRV was sold into this pool for 40 minutes straight, from multiple addresses - until the entire position was liquidated.
So who made these sales? It may have been a number of individuals from different interest groups: those who wished to protect AAVE, such as tokenholders and investors, passive holders of CRV who wished to realise gains on the rapid price spike, as well as traders taking profit, who earlier bought to defend the downside liquidation of the Curve Team.
Given the volume of selling from DeFi-aligned forces, the CRV price reaction was ultimately muted. The liquidation spike from around 62 cents to 74 cents is likely far less than was hoped for, and timely selling managed to avert any major debt to holders of Atokens (AAVE credit tokens).
It is still unclear as to whether either party ‘won’ here, as lack of a conclusive amount of bad debt in the protocol does not give a possibility for major profit-taking on either side. Now, AAVE is left with a low 7 figures of bad debt that is easily covered by their insurance fund, and Eisenberg is left with a liquidated account.