Nearly 200 million in bad debts bearing down, $AAVE An analysis of several possible future scenarios for the trend

Author: David, Deep Tide TechFlow

After the Kelp DAO hack, AAVE dropped from $112 to around $90 , a 20% decline in 24 hours.

At the same time, Aave also recorded $195 million in bad debt. I believe most of the previous AAVE holders who were caught in the crossfire, or those trying to capitalize on this news with contracts, are most concerned about one thing:

Is this 20% drop over, or just the beginning?

I tend to believe there’s still a short-term rebound, and the volatility isn’t over yet. Because what’s dropping now is actually sentiment, reflecting the market’s initial pricing of the impact of the negative KelpDAO event on AAVE.

The real variable that determines AAVE’s price movement is still who will fill the $195 million bad debt hole.

First, let’s quickly review the background.

After the Kelp hack, the hacker used forged rsETH as collateral to borrow $236 million in WETH from Aave. The money was borrowed, the collateral became worthless, and the $195 million bad debt is now hanging in Aave.

Although DeFi’s various nested and lending principles are complex, the essence of this incident isn’t complicated:

It’s AAVE incurring bad debt, which needs to be filled. If the hole can be filled, the issue is resolved; if not, it’s a much more serious situation.

You might ask, how does this relate to AAVE tokens themselves?

Is it reasonable to think that if a protocol loses trust and funds, its token will be sold off and go to zero? If the negative issue is resolved, will the token price recover?

Sentiment is one variable, but the mechanism by which the AAVE protocol fills the hole also influences AAVE’s price structurally.

Three scenarios that could affect the price

First, Aave has a mechanism called Umbrella to absorb bad debt, providing layered protections to reduce losses from bad debt, summarized below.

In simple terms, if the bad debt amount is too large—beyond what the initial layers can cover—then the protocol will need to use staked AAVE to fill the hole. This could theoretically trigger market sales, impacting AAVE’s price.

Therefore, for AAVE holders and traders, the key question is: how deep into the layers will the bad debt flow?

Here are my possible scenarios.

1. First scenario: The first two layers absorb the impact, AAVE holders don’t need to pay out of pocket

I checked the actual size of the Umbrella staking pools. The aWETH pool is about $55.8 million, while the hole is $195 million. The first layer can cover less than 30%, and the remaining roughly $140 million will flow into the second layer.

The second layer involves all WETH depositors sharing the loss proportionally.

Although $5.4 billion has already been drained by large players, Aave’s total WETH deposits still amount to tens of billions. Covering the $140 million gap would mean depositors bear about 2-3% loss. Not a large proportion, but for those who “just deposit to earn interest and have never touched rsETH,” this loss feels quite unfair.

This is the scenario I see as most probable. The first two layers absorb the hole, and AAVE holders’ principal remains unaffected.

This means the AAVE token itself doesn’t suffer direct financial loss; the 20% drop is purely driven by panic. Once Aave’s official confirms “no need to touch the third layer,” the market will breathe a sigh of relief, and the price could recover.

However, the speed of recovery depends on whether TVL can return. It’s easier for money to leave than to come back. Restoring it takes time and requires Aave to present convincing risk management improvements.

So even in the best case, AAVE’s price recovery will be slow. There might be a short-term rebound, but medium-term depends on how quickly TVL stops declining and the overall market environment.

2. Second scenario: The bad debt flows into the third layer, AAVE holders really have to pay

If the first two layers fail to contain the impact, governance votes will be triggered to reduce the principal from those who staked AAVE.

However, I think this scenario requires additional negative news to trigger it, and its likelihood is relatively low compared to the first.

For example, before a bad debt resolution plan is announced, large-scale outflows of WETH deposits continue, leaving fewer and fewer funds in the pool to share the loss. The haircut ratio in the second layer could be pushed to an unacceptable level, forcing the mechanism to go further down.

Or, during this window, ETH prices could plummet sharply, triggering a new round of liquidation failures, causing the bad debt to grow beyond the initial $195 million.

Once it reaches this stage, the situation changes.

Market has never seen stkAAVE truly slashed; this risk has always been priced as a theoretical clause, with near-zero weight. After an actual slash, everyone will need to reassess the tail risk of holding AAVE.

Stakers will demand higher returns to compensate; if not, they’ll withdraw, and the tokens will flood back into the market as selling pressure. The pressure on the price is much greater than in the first scenario, and the recovery cycle will be longer because it involves changing AAVE’s valuation model itself.

3. Third scenario: Even four layers of backing can’t fill the hole

This is very unlikely, but cannot be completely ruled out. Reaching this point would require multiple negative events happening simultaneously. If it does, the market will start questioning the entire security architecture of Aave, funds will continue flowing to competitors, and the token’s valuation center will shift permanently downward.

Overall, I believe the hole in AAVE will most likely be patched within the first two layers. Although the Umbrella staking pool is only about $55.8 million, even if more than half of the second layer’s WETH deposits are drained, its size still exceeds the remaining gap.

The current $90 price probably already reflects overly pessimistic expectations.

What should you watch for?

Which signals indicate that the worst phase has passed?

I personally focus on three things.

First is Aave’s official bad debt resolution announcement. It’s still in the “exploration” stage, with no concrete figures yet. Once released, the market will be able to clearly see how much was burned in the first layer, how much was deducted in the second, and whether the third layer will be involved in selling AAVE.

This event should significantly ease uncertainty, with the announcement serving as the most important catalyst.

Second is the stabilization of TVL. It doesn’t need to return to the peak of $26.4 billion, just stop declining week-over-week. Stabilizing TVL means depositors’ panic withdrawals have ended, and the protocol’s revenue base won’t continue to deteriorate, providing short- to medium-term guidance.

Third is the return of core market utilization to normal levels. Currently, USDT and USDC markets are at 100%, meaning depositors can’t withdraw funds. A utilization rate returning to 60-80% indicates liquidity is recovering, and the panic is essentially over.

This data can be seen directly on the Aave frontend interface, so it’s easy to monitor in real time.

Once two of these three signals appear, I think the worst phase is over. Until then, any price rebound should be viewed as a technical correction after an oversell, not a trend reversal.

Returning to the question at the start: Has AAVE dropped 20% enough?

My view is that the current price has probably already priced in some of the “worst-case” scenario, but the confirmation signals for the “best-case” haven’t appeared yet. During this middle ground, the price will fluctuate repeatedly.

For those looking to buy the dip, my advice is to wait for signals. Wait until the bad debt resolution announcement, TVL stabilizes, and utilization returns to normal—at least two of these before acting. By then, the price may have already rebounded somewhat from the bottom, and you’ll be acquiring a fundamentally clearer asset rather than a speculative token like a meme coin.

For traders, the volatility in the coming weeks will be high. Governance votes, every official statement from Aave, and large ETH price swings will all be amplified by the market.

When direction is uncertain, volatility itself can be a more reliable trading opportunity.

Finally, what impressed me most about this incident is that Aave’s contract code had no issues, yet the $195 million bad debt still occurred. The problem lies in the protocol’s choices—what collateral types to list, what loan-to-value ratios to set, and how many other protocols to partner with.

In the crypto DeFi world, I increasingly feel like the ships in the “Battle of Red Cliffs” from the Romance of the Three Kingdoms—protocols are chained together, and a single spark from the east wind can cause a chain reaction of destruction.

DeFi remains too complex for most non-professional newcomers. This lesson may be hard to fully absorb at the protocol level, but the trading opportunities created by volatility need to be maximized.

Note: This article is based on public data, mechanism reasoning, and personal judgment. It does not constitute investment advice. DYOR.