As market charts flip from red to green, crypto lending is enjoying a resurgence of interest after a particularly dismal second quarter. Figures from Galaxy Research show that $11.33 billion left the sector in Q2 — a decline driven in part by a crisis of confidence in lenders triggered by the Kelp DAO hack in April, which left users of the most trusted protocol, Aave, unable to access their ETH.

Since the beginning of July, however, total lending value locked — the assets supplied to onchain lending markets, where deposits double as borrowable collateral — has climbed by more than 55% from the end of Q2, to sit around $56 billion today, according to DeFiLlama.

That growth also means the honeypot has grown larger. Lending is one of DeFi's foundational building blocks, and the interconnections run deep: tokens borrowed in one protocol are often redeposited or pledged as collateral in another. Can users trust interlinked DeFi lending protocols in an age of AI-assisted hacks, when an exploit at any single protocol can set off a chain of devastating effects for the other protocols connected to it?

Stani Kulechov, founder and chief executive of Aave Labs, told Cointelegraph's Magazine that the problem is now top of mind.

“When a protocol accepts a token as collateral, it is also accepting that token’s bridge, its verifier configuration, its oracle and its issuer’s operational security.”

And that is exactly what landed Aave in trouble.

An expanding attack surface

When hackers exploited a Kelp DAO cross-chain route in April, they created 116,500 unbacked rsETH, the protocol’s liquid restaking token, worth about $290 million at the time, and many of those tokens were posted as collateral to borrow other assets across Aave markets.

Even though Aave’s own contracts were not breached, the protocol still saw deposits fall by around $15 billion in the days after the exploit, and it had to freeze its rsETH and wrsETH markets. Galaxy data shows the lending market contracted by 16.78% in Q2.

Kulechov said Aave now takes a more holistic approach to security.

“We rebuilt our approach around that wider view. Our starting point is that security can’t stop at the smart contract,” he said, adding that traditional reviews “missed the risk sitting in the bridges, verifier networks and other infrastructure an asset depends on.”

Users of lending protocols will similarly need to judge how exposed a protocol is to external and internal risks.

“Every wrapper, bridge and oracle between the lender and the underlying asset is another place a loan can go wrong,” said Thomas Wu, chief financial officer of Bitcoin-backed lender Ledn.

Sid Powell, co-founder and chief executive of crypto credit platform Maple, told Magazine that “serious lenders” should assume a borrower can fail at any time and work backward from there.

“What am I holding, where is it, can I see it in real time, and how quickly can I get to it if something breaks?” he said.

When security fails, containment matters

Sam MacPherson, chief executive of DeFi lender Spark, said that beyond smart contracts, his team also reviews governance design, operational security, collateral quality, liquidity management and dependencies across the wider ecosystem.

Spark began phasing out rsETH on SparkLend in January — before the April Kelp exploit — after assessing that “its low usage and revenue” did not justify the “additional risk” created by supporting it.

Kulechov said Aave has introduced similar mechanisms: every asset is re-reviewed quarterly and “again after any material change.” He added that the protocol has already started “an orderly wind-down” on six networks that did not meet its chain-level standards.

“No protocol can control the entire ecosystem, but it can control how much that risk it takes on and how quickly it responds,” Kulechov said.\nWhile preventing failures is the aim, MacPherson noted that protocols also need procedures in place to respond if something happens.

“Preventing losses is only part of the challenge. Protocols also need to demonstrate how a loss would be contained if something does go wrong,” he said.

The margin for human error

Shawn Owen, founder and chief executive of SALT Lending, said human error remains one of the biggest vulnerabilities — and the easiest to overlook.

“A lot of the biggest losses have come down to key management, access controls or someone getting socially engineered, and a smart contract audit won’t catch any of that,” Owen said.

Additional risks materialize when assets are deployed elsewhere to generate interest. Crypto lenders learned that lesson the hard way during 2022’s brutal market unwind, when lenders like Celsius, Voyager and BlockFi all imploded after taking on risks customers either didn’t understand or weren’t expecting.

To minimize its attack surface, Ledn keeps client Bitcoin with qualified custodians rather than lending it out to generate additional yield. Wu said every transaction is an additional point where something can go wrong, “so the fewer there are, the lower the risk of a breach.”

“The only way to take those risks off the table is to keep client Bitcoin in segregated custody, with tight controls and as few movements as possible,” he said.

Powell warned that when deposits start coming in faster than a manager can find good places to lend, the pressure to maintain yields can lead to bad choices.

“So they take on a little more risk to get there. Maybe the collateral standards get looser, or they lend to a borrower they’d have turned down a year ago. [...] The managers who hold up in a downturn are usually the ones who were willing to say no to capital when they didn’t have a good place to put it,” he said.

Can AI make lending safer?

For all the recent headlines about AI hacks, exploits and agents escaping human control, AI may actually be able to help make crypto lending safer.

Aave is already using AI-assisted testing alongside its conventional security processes. According to Aave’s AI-assisted security review, the protocol used mutation testing to deliberately introduce bugs into its V4 contracts, and its test suites caught 271 of 304 injected vulnerabilities.

In a recent review of the V3 and V4 codebases, three AI security tools generated 71 findings. After manual review, 20 were considered valid — while the other 51 demonstrated why human security experts will likely remain employed for some time to come.

“AI is very good at breadth and speed, but around 70% of the raw findings were false positives, so expert judgment stays essential,” Kulechov said.

AI is something of a double-edged sword, however, as its permissions, protocol knowledge and decision-making processes become another potential attack surface.

“As AI agents start managing capital onchain, their permissions, inputs and decision logic become things that need to be secured just like a contract,” Kulechov said.

With Aave’s V4 contracts already run through mutation testing, its quarterly asset re-reviews and its network wind-downs are the concrete mechanisms to watch as lending balances rebuild.

So, as crypto lending grows again, the challenge is not just keeping the code secure, but making sure every new part of the puzzle is understood, monitored and contained when something goes wrong.

Source: Cointelegraph Magazine