A significant liquidity crunch has hit Aave following a $300 million spike in borrowing after the KelpDAO hack. Users on the decentralized finance platform borrowed against their Tether deposits, illustrating the desperate measures taken when liquidity pools become inaccessible. The KelpDAO exploit on April 18 led to a massive outflow of assets from Aave. Whales quickly withdrew billions, draining liquidity and causing utilization rates of stablecoin pools like USDT and USDC to reach 100%.

As a result, depositors found themselves unable to withdraw their funds, forcing them to take loans against their own deposits, often at a loss. The aftershocks of the KelpDAO hack have reverberated across the stablecoin markets in ways that were not immediately apparent. According to data from Chaos Labs, users on Aave borrowed approximately $300 million against their Tether deposits within the first 24 hours following the exploit. This surge in borrowing is not indicative of market demand; rather, it reflects a dire situation where depositors have been effectively locked out of their funds due to the liquidity crisis.

To understand the gravity of this situation, consider a traditional bank refusing to process withdrawal requests. In such a scenario, customers would be left with little choice but to take out loans against their own deposits, a desperate strategy to access liquidity. "We're now seeing some negative secondary effects of illiquidity in Aave stablecoin markets," said monetsupply.eth, the pseudonymous head of strategy at Spark, a competing DeFi lending platform. "Because users can't withdraw due to 100% utilization, there has been a ~$300 million increase in borrowing with USDT collateral in just the past day since the rsETH exploit." Understanding how Aave is designed to function reveals why the KelpDAO exploit has had such a profound impact.

Aave operates as a decentralized finance (DeFi) protocol, enabling users to lend and borrow cryptocurrencies without intermediaries. Unlike traditional banks, Aave runs entirely on code on a public blockchain, which eliminates human gatekeepers. In the Aave ecosystem, users deposit assets into lending pools, earning interest on their deposits while others borrow from those pools using crypto assets as collateral, which exceeds the loan amount. The system is designed to self-correct through dynamic interest rates; when borrowing demand surges, rates increase, encouraging more deposits and vice versa.

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However, the foundational assumption underlying this model is that there is always enough liquidity available for lenders to withdraw their funds and for borrowers to exit their positions when needed. When this assumption breaks down, instability ensues. The KelpDAO exploit, which involved the manipulation of KelpDAO's bridge infrastructure, released 116,500 rsETH tokens, representing roughly 18% of the token's circulating supply and valued at approximately $292 million. These tokens, however, were fake and unbacked.

When deposited into lending protocols, primarily Aave, they allowed for the borrowing of real ETH and other assets like wrapped ether (wETH). As 0xyanshu, a crypto operator known for expertise in on-chain finance, stated, "That [borrowed] WETH is gone. The rsETH holding its place in the vaults is worth whatever an unbacked claim is worth — approaching zero on the L2 side, where 20+ chains held bridged rsETH backed by a now-empty mainnet lockbox." Upon the discovery of the exploit, Aave's founder, Stani Kulechov, confirmed that while the exploit was external and did not compromise Aave's contracts, the protocol took swift action to freeze rsETH markets on both V3 and V4. This move, while necessary to stop further losses, inadvertently triggered the chain reaction that led to the $300 million borrowing surge.

As news of the exploit spread, large holders, or whales, such as Justin Sun and the MEXC exchange, rushed to withdraw billions of dollars worth of cryptocurrencies from Aave's liquidity pools. Their rapid withdrawal actions drained liquidity pools at an alarming rate. Analyst Duo Nine highlighted that when the rsETH exploit occurred, Aave faced significant bad debt, leading to the ETH market reaching 100% utilization, making it impossible for users to withdraw their ETH from Aave. This situation quickly escalated, impacting the USDT and USDC pools as well, which also reached 100% utilization due to the exodus of over $6 billion in assets from the protocol within hours.

With every dollar of those assets borrowed out, depositors were left with no remaining funds for withdrawal; thus, the borrowing surge began. Trapped depositors, unable to access their USDT and USDC, resorted to borrowing against their locked deposits. Many chose to take loans against their USDT/USDC, often accepting a 10-25% loss in the process, merely to extract liquidity from the system. This action was not a well-thought-out trading strategy but rather a desperate measure to regain some access to their frozen funds.

As noted by Duo Nine, users were effectively borrowing GHO, DAI, or USDe against their locked USDT or USDC, effectively accepting 75 cents on the dollar to mitigate their losses.