DeFi Market Faces Cascading Liquidation Crisis Due to rsETH Security Incident

The DeFi market is facing a growing risk of a cascading liquidation crisis due to the ongoing rsETH security incident. The incident has caused a significant tightening of stablecoin market liquidity, making it difficult for users to close their positions and resulting in a high risk of widespread losses for ETH providers.

According to recent reports, around 16.5% of the ETH market is backed by rsETH, which could lead to significant losses if related losses are spread equally across both mainnet and cross-chain environments. This has resulted in ETH providers tending to exit as quickly as possible, causing market utilization to reach a critical level of 100%.

Furthermore, borrowing rates are not sufficient to incentivize wstETH, weETH, and other leveraged positions to deleverage and release liquidity, exacerbating the crisis. Additionally, users who have borrowed stablecoins such as USDT against ETH collateral are finding it difficult to close their positions in time, even with rising stablecoin borrowing rates.

As a result, two major distorted incentives are emerging: first, ETH holders are unable to adjust their collateral health ratio, and liquidators cannot withdraw and sell collateralized assets; second, stablecoin depositors are motivated to 'exit indirectly' by lending out other stablecoins, allowing them to lock in about 75% of their fund recovery at relatively low cost.

However, this situation is further complicated by the recent lowering of the maximum borrowing rate cap (slope2) by Aave, which is weakening deleveraging incentives and significantly increasing the risk of systemic market failures. In light of these developments, it is essential for lending markets that rely on liquidity pools and rehypothecation to prioritize liquidity.