In any lending protocol, risk isolation is a critical function. It prevents the failure of a single, high-risk asset from causing cascading liquidations that could compromise the stability of the entire protocol.
Aave V4 introduces a new architecture that expands on Aave V3's approach to risk management. This post will review how risk and liquidity are managed in Aave V3, explain the new V4 architecture, and show how this new model handles risk segregation without fragmenting liquidity.
Aave V3 Tools for Managing Risks
Aave V3 manages risks for the protocol and users through a blend of asset-specific and market-specific mechanisms. These tools limit how assets can be used as collateral or borrowed against others, helping to onboard new assets by containing risks and limiting unintended exposure.
Asset-Specific Configurations
Asset-specific configurations compartmentalize risks at the individual asset level, preventing contagion across the broader Aave ecosystem.
Isolation Mode safely introduces new or volatile assets into Aave markets by limiting how they can be used as collateral. When supplying an "Isolated" asset as collateral: (i) it becomes the only asset enabled as collateral in a user's position, preventing the addition or enablement of other collaterals; (ii) borrowing against it is limited to a governance-approved set of assets, typically stables; and (iii) total borrowing is capped by a per-asset debt ceiling. This isolates risks, restricts debt exposure to stable assets, and shields other core collaterals like ETH from spillover.
Siloed borrowing limits borrowing risks for volatile assets by enforcing single-borrow positions. Users borrowing a siloed asset cannot borrow any other assets simultaneously. This isolates insolvency risks and prevents amplification through multi-asset debt.
Efficiency Mode
Efficiency Mode (E-Mode) restricts borrows to correlated asset pairs, such as borrowing WETH against ETH LSTs and LRTs, to enable higher loan-to-value (LTV) ratios than standard mode. E-Mode groups correlated assets together, reducing unnecessary liquidations from small price fluctuations.
Aave V3.6 introduced upgrades to liquid E-Modes that improve risk segregation by allowing assets to be listed in E-Mode without requiring them as collateral in the default configuration.
Market-Specific Configurations
Market-specific configurations allow Aave V3 to deploy independent instances with segregated liquidity pools, customized asset listings, and tailored risk parameters for each asset.
The Aave V3 Core Instance offers broad asset support with conservative risk parameters for general accessibility. The Prime Instance focuses on correlated asset types with higher borrowing capacity. The Horizon RWA Market isolates tokenized real-world asset (RWA) collaterals, such as VanEck's VBILL or Superstate's USCC, for exclusive use by whitelisted institutional borrowers.
Aave V4's Approach to Risk Management
New Architecture
Aave V4 introduces a Hub and Spoke architecture that changes how liquidity and risk are managed.
In V4, all assets on a network are stored in a Liquidity Hub. Users do not interact with the Hub directly. Instead, they supply and borrow through Spokes, which connect to the Hub and provide specific lending and borrowing functionality. Each Spoke has its own rules and risk settings, and can be optimized for different use cases, such as stablecoins, staked ETH derivatives, or higher-risk assets.
The Hub tracks which Spokes can access which assets and sets limits on how much liquidity each Spoke can draw. This allows V4 to support specialized markets without fragmenting liquidity. For example, Isolation Mode can be implemented as a dedicated Spoke with its own parameters and access controls, while still drawing from the shared liquidity in the Hub.
This setup provides more granular risk segregation than V3 without sacrificing liquidity. Hub safeguards, such as per-Spoke limits and throttling, protect protocol solvency, suppliers, and borrowers.
Risk Premiums
V4 also introduces Risk Premiums, a rate mechanism that prices borrow rates based on collateral quality rather than applying uniform rates market-wide.
The Hub sets a base rate driven by supply and demand. Each asset has a Collateral Risk score, which is low for blue-chips like ETH and higher for more volatile and long-tail assets. User Risk Premiums add up scores across collaterals, scaling borrow costs individually. Users with higher-quality collateral get better rates and aren't required to subsidize riskier borrowers.
Dynamic Risk Configurations
Lastly, V4 includes per-Spoke add and draw caps, freeze and pause functions, and dynamic risk configurations. These allow Aave governance to update risk parameters and create new reserve configurations that apply only to new positions, leaving existing ones under prior parameters.
Users with existing positions are only affected when they take on additional risk, such as borrowing more, withdrawing collateral, or disabling collateral. Dynamic risk configurations give risk managers more flexibility to address changing market conditions or handle asset offboarding.
Tightened parameters, such as reduced LTV, higher liquidation thresholds, or borrow disabling, affect only new borrows and supplies. Existing positions remain unchanged, avoiding forced liquidations or cascading events. Long-tail positions, including low-activity or legacy holdings, are preserved without disruption, allowing for safer de-risking of problematic assets over time.
Why This Matters
Aave has grown to tens of billions of dollars across a wide variety of assets. Scaling to trillions of dollars and millions of users requires an architecture that can maintain Aave's excellent risk management track record without fragmenting liquidity across individual, isolated markets.
V4's design supports this goal. Risk premiums give suppliers and borrowers rates that reflect the actual risk of their positions, making the protocol more competitive as it scales. Customizable Spokes let developers build specialized markets that tap into unified liquidity, expanding what Aave can support without the bootstrapping friction of isolated pools and without introducing a bunch of risk to the protocol. And dynamic risk configurations allow governance to adapt to changing conditions without disrupting existing users, which becomes more important as the protocol grows in size and complexity.
Aave V4 uniquely positions Aave to handle the next order of magnitude of growth.