Babylon’s Aave Plan Could Expose Wrapped Bitcoin Suppliers to Deficits

Babylon Labs’ proposed native-Bitcoin lending design for Aave V4 would pay permissionless liquidators in Wrapped Bitcoin (WBTC), potentially exposing suppliers to a Hub deficit if escrowed collateral falls short.

The design would let borrowers lock Bitcoin (BTC) in Taproot vaults on the Bitcoin network. A transfer-restricted accounting token would represent each position inside Aave, while the BTC remains on Bitcoin rather than being wrapped or bridged to Ethereum. The first use case is borrowing stablecoins against BTC. The liquidation details extend Babylon’s earlier native-Bitcoin borrowing coverage.

The proposed permissionless liquidation route uses a separate BTC Vault Swap Spoke to draw WBTC from a shared-liquidity Hub and pay the liquidator at an oracle price minus a sell discount. That lets liquidation settle before the Bitcoin collateral can be redeemed. The seized vault would remain in escrow until a registered arbitrageur repays the Hub draw, including accrued interest, acquires the vault and completes redemption. A challenge window makes redemption a process of multiple days.

The shortfall path applies only if collateral value drops below debt. If the vault’s value falls below its Hub debt, an arbitrageur could still acquire it, but repayment would be capped at the vault’s value minus a reserved margin for the arbitrageur. The unpaid balance would be recorded as a Hub deficit in the same transaction. Aave V4’s framework assigns deficit exposure to suppliers of the asset drawn from the Hub, placing WBTC suppliers in that exposure path if WBTC funds the liquidation. No existing deficit has been reported.

WBTC is the proposed launch settlement asset, though the integration can use another wrapped-Bitcoin token. The final Hub, draw cap, sell discount, arbitrageur margin and WBTC-specific backstop are not set. Initial general-purpose coverage recommendations named Core Wrapped Ether (WETH), Core USD Coin (USDC) and Core Tether (USDT); WBTC was not among them.

A separate, permissioned route would let registered application vault keepers repay the debt and redeem seized BTC to their own Bitcoin key without drawing WBTC through the Swap Spoke. Under that route, registered keepers would handle repayment and direct redemption.

The proposal remains under community review. Next steps include feedback and risk analysis, followed by a possible Snapshot vote. If that vote passes, an on-chain AIP with full risk parameters would go to governance.