Modeling the Risks Within the Protocol Aave, With an Application to Portfolio Allocation

Abstract

Decentralized Finance (DeFi) lending and borrowing protocols enable investors to take leveraged long and short positions on digital assets without centralized intermediaries, but expose them to a distinctive form of risk: on-chain liquidation triggered by debt and collateral value fluctuations. In this work, we provide a detailed formalization of Aave's lending, borrowing, and liquidation mechanisms, grounded in the protocol's open-source implementation. In doing so, we propose a mathematical modeling of the risk of liquidation, including some stochastic approximations with the purpose of efficient analysis, with different applications. Among them, portfolio optimization problem.