Native Bitcoin collateral on Aave triggers WBTC pool deficit

Babylon Labs proposes a Bitcoin market on Aave V4

A new proposal from Babylon Labs, dated Oct. 14, would create a lending market on Aave V4 that accepts native Bitcoin as collateral. Collateral is the asset a borrower locks up to back a loan.

Under the design, the borrower's Bitcoin stays in Bitcoin. To pay off loans quickly when a position is liquidated, the system borrows Wrapped Bitcoin (WBTC) instead. WBTC is a token on another blockchain that is meant to represent Bitcoin.

The proposal says the people or pools supplying WBTC to fund those payouts would carry any settlement shortfall, and the plan does not name a funded WBTC backstop.

Key points from the proposal

• Babylon Labs' Aave V4 proposal would keep collateral native on Bitcoin while borrowing WBTC to settle open liquidations.
• Hub suppliers would finance escrow until a permissioned buyer takes over; direct keepers could fund their own liquidation.
• Escrow shortfalls would become Hub deficits, while the proposal leaves a funded WBTC backstop unspecified.
• The Aave Request for Comment lists feedback, a conditional Snapshot vote, and an eventual on-chain proposal with full risk parameters as next steps.

How the two liquidation routes work

A borrower would lock BTC in an individual Taproot vault on Bitcoin. Aave would recognize it through a restricted ERC-20 accounting token that cannot be traded between users. The WBTC used to settle liquidations is a separate asset.

When a position becomes liquidatable, an outside liquidator would repay the borrower's debt through an adapter. The seized vault would then be sold to the BTC Vault Swap Spoke, a settlement component that draws WBTC from an Aave shared liquidity pool, called a Hub, and pays the liquidator at an oracle-based price minus a sell discount.

That exchange lets the liquidator leave with a transferable asset in the same transaction. The Swap Spoke keeps the vault in escrow and owes interest on the borrowed WBTC. Later, an arbitrageur with redemption rights would buy the vault by repaying the draw and accrued interest, then claim the BTC on Bitcoin.

An alternate route lets authorized application vault keepers repay the borrower's debt and redeem the seized vault directly to their own Bitcoin key, skipping the Swap Spoke's Hub draw. On that route, the keeper finances repayment and the wait for Bitcoin settlement.

If a borrower's entire debt is cleared before the vault's value is used up, the liquidator must compensate the borrower for the remainder in WBTC at the liquidation-bonus discount. The article notes that even the direct keeper route can require WBTC for this surplus payment.

How a shortfall becomes a Hub deficit

The Swap Spoke's WBTC borrowing creates a second debt alongside the borrower's original loan. Its repayment depends on the escrowed vault attracting an eligible buyer on the specified terms.

If the vault's current value no longer covers its Hub debt, an arbitrageur can still buy it. Repayment is capped at the vault's value less a reserved arbitrageur margin, and the unpaid balance is reported to the Hub as a deficit in the same transaction. The reserved margin is meant to preserve the incentive to buy the vault and lets the mechanism complete a purchase while recognizing a loss.

Aave V4's deficit documentation separates recognizing a deficit from eliminating it. Covering a deficit consumes supplied Hub shares belonging to an authorized active Spoke, so some supplier's capital must bear the cost of restoring the accounting balance.

TokenLogic's September coverage framework places deficit exposure with suppliers of the specific Hub asset drawn and tracks the originating Spoke separately. Under that framework, a shortfall on the proposed WBTC draw would affect suppliers of that Hub asset unless allocated protection absorbed it.

That framework describes DAO deficit offsets as the first loss layer before Umbrella protection where that protection is configured. Its initial recommendations cover three Core lending markets: WETH, USDC and USDT. WBTC financing falls outside that initial scope.

What is confirmed

Babylon Labs published the proposal on Aave's governance forum on Oct. 14. The plan would keep collateral native on Bitcoin and borrow WBTC to settle liquidations. The Aave Request for Comment lists feedback, a conditional Snapshot vote, and an eventual on-chain proposal with full risk parameters as next steps.

What is still unclear

The proposal does not specify a funded WBTC backstop. The final funding Hub, draw limits, and any dedicated protection are left to the market's eventual risk allocation, and backstop funding is described as a separate decision.

Why it matters for Aave suppliers

The design separates fast liquidation from the slower redemption of Bitcoin collateral. The open route draws WBTC from an Aave Hub until a permissioned buyer takes over the vault. If a vault's value no longer covers its Hub debt, the unpaid balance would be reported as a deficit, and covering that deficit would consume supplied Hub shares. The framework tracker places that exposure with suppliers of the drawn Hub asset.

Sources

• CryptoSlate

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