Aave V4: Curbing Profit-Driven Liquidity for a Sustainable Decentralized Finance Future

Author: ian.btc | 0xWorkhorse, compiled by: Shaw Golden Finance

As Aave's total locked value (TVL) skyrockets to $70 billion, accounting for over 80% of the DeFi lending market, the protocol is preparing to launch its most ambitious upgrade yet: Aave V4 — expected to be released in Q4 2025, and I am eagerly looking forward to its arrival.

As I mentioned earlier, the V4 upgrade introduces a centralized radiating architecture that addresses the “profit-driven liquidity” trap—where short-term capital that floods in during incentive programs disappears without a trace after the rewards vanish—while laying the groundwork for truly frictionless cross-chain operations.

By centralizing liquidity, modularizing risk, and creating pathways for institutional adoption, V4 not only positions Aave as a market leader but also becomes a potential liquidity network for the entire DeFi space.

Profit-seeking Liquidity Trap: The Fatal Weakness of DeFi

Since the rise of the liquidity yield craze during the DeFi Summer in 2020, DeFi has been struggling with a structural flaw: profit-driven liquidity. DeFi protocols typically rely on token issuance or yield incentives to attract capital, thereby attracting liquidity providers (LPs) chasing high annual interest rates/annualized returns. However, once the yields gradually decrease, these funds tend to flow to more profitable opportunities.

The result is: TVL is unstable, borrowing costs are rising, and the lending market is weak.

The bear market after 2022 is filled with this behavior – many incentive-driven forks and Layer-2 markets saw their TVL plummet by 80%-90% after the token issuance cliff arrived.

Although participants like us benefit in the short term, the overall impact on the broader DeFi movement is not particularly positive.

In short, this cycle undermines the promises of stability and decentralization in DeFi. Although Aave dominates with $28 billion in active loans and recently earns $15 million a month from flash loans, interest, and liquidations, it also faces similar challenges.

CEO Stani Kulechov recently emphasized the risks:

“We are proud of the work that the Aave Labs team has done on Aave V4, which is our most ambitious version to date. After 18 months of design, we are directly addressing the core issues of liquidity.”

The solution of V4 lies in a reimagined architecture that prioritizes user retention over short-term incentives.

Hub-and-Spokes: Restructuring Liquidity for Stability

The core of Aave V4 is its Hub-and-Spokes model, a structural reform designed to eliminate liquidity fragmentation and speculative behavior.

The liquidity hub acts as a centralized settlement layer, aggregating funds, serving as the pillar for protocol risk management, accounting, and governance. Spokes are modular extensions connected by credit lines governed by DAO, supporting specialized lending strategies—such as margin trading, AMM collateral, or tokenized real-world assets (RWA)—without causing liquidity isolation.

This setup completely overturns the incentive model.

Liquidity providers no longer chase yields in decentralized pools but instead provide funds to a central entity, which dynamically allocates the funds to various branches based on demand and risk parameters. The new reinvestment module can automatically direct idle funds to low-risk, high-yield investment opportunities, further enhancing efficiency while reducing trading costs and increasing returns.

As Stani pointed out, this feature was “temporarily” added inspired by Ethena, allowing the protocol to deploy idle funds in the pool to high liquidity yield strategies. Early simulations indicate that this can improve capital efficiency by 20%-30%, which is quite remarkable.

All of these combined create what Aave refers to as the “liquidity network effect.” By concentrating funds in 1-3 centers of each network (for example, tailored for stablecoins or volatile assets), V4 ensures that deep liquidity pools do not evaporate after incentives.

For participants like us, this means more stable returns; for borrowers, this means lower slippage and continuous access to funds.

Governance as a Guardrail

With the emergence of all these technological innovations, it is noteworthy that the success of Aave V4 actually depends on its DAO-driven governance model, which replaces ad-hoc incentives with (hopefully) structured control.

In short, the DAO sets credit limits and risk parameters for each Spoke to ensure that liquidity allocation aligns with preset boundaries. This “risk ladder” approach segments the Hub by asset class—stable assets adopt a conservative approach, while niche markets use an experimental one—ideally, this method can isolate potential losses.

For example, if a Spoke of a high-risk asset fails, its upper credit limit can prevent the crisis from spreading to the Hub, which can prevent a loss similar to Mango's $100 million loss on Solana in 2022 — the limit control measures in V4 can mitigate losses.

Therefore, when vulnerabilities inevitably occur, there are some means to respond.

The improved settlement engine further enhances resilience, effectively addressing the issue of insufficient collateral and protecting core assets. This governance-first model ensures that V4 can support innovative use cases without sacrificing stability, which is a key step in ending the boom and bust cycles of speculative capital.

Economic Flywheel: Sustainable Earnings Outweigh Short-Term Profit Inducements

Well, there's another highlight on how to deal with profit-seeking liquidity: the economic design of V4. This step is significant as it truly breaks free from the constraints of profit-seeking speculative liquidity. By aggregating funds in the Hub, Aave reduces the demand for token issuance, whereas on other competing platforms, token issuance may account for over 50% of protocol expenditures — which is quite astonishing.

In contrast, V4 introduces a revenue-sharing model with third-party Spokes. Developers building dedicated markets—such as Spokes for tokenized real estate or gaming assets—can leverage the liquidity of the Hub while returning a portion of the fees to the DAO.

This creates a flywheel effect: more Spoke attracts more users, increases Hub deposits and fee income, thereby enhancing the DAO's treasury.

Aave's current financial situation highlights its potential—year-to-date revenue is $86 million, having repurchased over 100,000 tokens worth approximately $27 million, which has reduced the circulating supply and increased the token's value. The structure of V4 may further amplify this effect, as the expansion into new markets could double fee revenue. More revenue means higher annualized yields and more satisfied participants.

Summary

Although V4's main focus may not be on curbing profit-seeking liquidity, I believe this will be a huge side benefit that fundamentally changes the way DeFi yields operate.

In addition, all the factors mentioned above have also attracted institutional investors who have traditionally been cautious about the volatility of DeFi. By curbing speculative capital flows, liquidity centers provide the depth and stable capital pools that enterprises need, similar to the market depth in traditional finance.

The isolated collateral vault (compatible with custodians like Gnosis Safe) and other features will allow institutions to participate without exposing assets to volatile markets, while strict credit limits ensure predictability of risk.

All of these are conducive to adoption and may release a significant amount of idle capital, as hedge funds and asset management companies can utilize the infrastructure of V4 for arbitrage or tokenized asset lending without worrying about capital outflows after incentives.

In conclusion, V4 is ambitious and exciting. In my opinion, its launch is likely to mark an important turning point for DeFi — and will undoubtedly signify a significant change in the way I engage in liquidity yield farming.