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I am a newbie in the blockchain/Web3 space and trying to understand the AAVE protocol.

Suppose a borrower deposits 1 ETH whose value is 500 DAI Tokens(500$) as collateral to borrow 100 DAI Tokens(100$) on Aave (the Stable APY and the time the loan is borrowed for is more than enough to repay the lender with Interest.).

The Borrower Takes the Loan.

In this time if the value of ETH falls to 50DAI (50$), the collateralization ratio and Health Factor decreases, and the borrower's collateral is liquidated to cover the outstanding debt. However, the liquidation of the collateral is not sufficient to cover the outstanding debt, and Aave incurs a loss of 50$.

How does AAVE Counters this scenario?

Things I have thought of :-

  1. Overcollateralization : the Stable APY and the time the loan is borrowed for is more than enough to repay the lender with Interest but still it lost 50$.

  2. Liquidation : still looses 50$.

what can AAVE possibly do in this situation?

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  • The loan is liquidated with a health ratio when the collateral can still cover the repayment. For normal market conditions, this is more or less guaranteed to work. For irregular market conditions like market crashes of deliberate attacks like with massive CRV short things get more interesting

  • If a loan goes underwater, then Aave stakers act as the backstopper of the protocol. Their staked AAVE tokens are sold until the protocol is solvent again.

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  • Correct me if I'm wrong, but the safety module is not the only backstop nor it comes into action automatically. Could you expand how Aave clears its bad debt? After the CVR attack last year it was left with sizable bad debt. Has it been cleared now? I see there was a governance vote, but it does not mention the safety module: app.aave.com/governance/proposal/?proposalId=146
    – kfx
    Apr 19 at 14:01
  • For such details, I suggest you go to read Aave governance forum discussions and else yourself. Everything is there, open and public, so with some efforts you will find details you are asking.
    – Mikko Ohtamaa
    Apr 19 at 14:41

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