AAVE V4 Introduces Risk Premium, Redefining How DeFi Lending Rates Work

AAVE is preparing a major shift with Version 4, and at the center of it is a new concept called Risk Premium. The update reworks how interest rates are calculated in lending markets, aiming to fix a long-standing issue where borrowers with very different risk profiles often paid nearly the same rates.

With liquidity becoming more centralized under AAVE’s hub-and-spoke design, this change is positioned as a necessary step to keep the system balanced.

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Why Earlier AAVE Models Struggled with Collateral Risk

In earlier AAVE versions, V3 included plans to optimize the economy by reusing the collateral. The assets pledged to be used as collateral would be converted into aTokens, which could be reused in the lending liquidity.

Source: X

This ensured that the user could accrue interest while borrowing. The AAVE founders, Stani Kulechov, appreciated the idea behind the design.

However, this efficiency came with trade-offs. Every AAVE market was a shared collateral pool, which means that every asset within it was, in a certain economic sense, interdependent.

The interest rates were a function of the utilization ratio of the loaned asset, not a function of the riskiness of the assets backing a loan. Two users taking out loans of a similar value might pay similar levels of interest, regardless of one being in ETH versus a governance token.

There were risk controls. Adjustments to concerns like loan value or penalties for a liquidation depended on the value of the collateral.

However, these did not affect how much a customer would borrow or when the liquidation would occur. They did not even impose costs on the customer regarding the risk that the customer’s position introduced to the pool.

This became a larger issue because the plan by AAVE was to move the liquidity from many spokes to a single hub. In such a system, it would create a greater risk for the entire system if it were to allow riskier accounts to borrow funds at the same price as risk-free accounts.

How Risk Premium Reshapes Borrowing in AAVE V4

The AAVE V4 introduces a Risk Premium that correlates the risk of a collateral asset with the price of borrowing. Every collateral asset will receive a Collateral Risk Score, expressed through Basis Points. More secure assets, such as ETH, will receive a score that is very close to zero.

The protocol also determines the value that the borrowed money is collateralized for. It does so in a manner that considers the least-risked assets first, proceeding to the riskier ones if necessary for the calculation. The protocol further calculates the risk score for the value of the position, which is known as the User Risk Premium.

SAVE V4 applies a premium to the interest amount rather than increasing the loan amount. The borrowers would receive a loan amount that is displayed on the screen. The premium amount is displayed in the form of premium shares over a period of time, and there is no hidden cost.

In reality, for instance, if a person borrows GHO at a base interest rate of 5% with ETH as collateral, they might have to pay no more than 5%. Another person taking out a loan for the same amount but with riskier collateral might have to pay 8%.

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