Aave Proposes Bitcoin Lending Market Amidst WBTC Pool Deficit

Design Overview

Aave's proposed native Bitcoin lending market would keep collateral in Bitcoin while borrowing wrapped Bitcoin (WBTC) to pay outside liquidators. The design separates fast liquidation from the slower redemption of Bitcoin collateral, drawing WBTC from Aave's shared liquidity pool until a permissioned buyer takes over the vault.

Mechanics of the Proposed Market

Hub suppliers would finance fast exits before permissioned buyers acquire the vaults, with escrow shortfalls reported as deficits. A borrower would lock BTC in an individual Taproot vault on Bitcoin, and Aave would recognize it through a restricted ERC-20 accounting token that cannot be traded between users. The WBTC used for liquidation settlement is a separate asset.

Liquidation and Redemption Routes

The proposed market includes two liquidation routes: an open route and a direct keeper route. The open route draws WBTC from Aave's shared liquidity pool, called a Hub, until a permissioned buyer takes over the vault. The direct keeper route lets an authorized operator finance repayment and redeem the BTC itself.

Deficit and Risk Allocation

The proposed loss-recording mechanism leaves backstop funding as a separate decision. Liquidity can constrain the open route before a deficit occurs. Babylon's public safety documentation says permissionless liquidations revert if Hub WBTC liquidity or the Swap Spoke's allowance is insufficient.

Governance and Configuration

The ARFC assigns governance of both Spokes and their funding Hubs to Aave DAO. It also assigns a separate Swap Spoke configuration role to a 2-of-3 multisig of LlamaRisk, Babylon Labs and Aave Labs. Babylon protocol governance would control its configuration and actor sets through a public timelock.

Conclusion

Aave's proposed native Bitcoin lending market has significant implications for the cryptocurrency market, particularly in the event of a market downturn. The design separates fast liquidation from the slower redemption of Bitcoin collateral, drawing WBTC from Aave's shared liquidity pool until a permissioned buyer takes over the vault.