A major security breach at Kelp DAO has sent shockwaves through the market, triggering a sharp 10% correction in ZRO as the protocol paused its rsETH contracts. The LayerZero token plummeted from $2 to $1.40 amid the fallout, while a separate $2.88 million leveraged long liquidation on HyperLiquid amplified the selling pressure, signaling a rapid retreat of liquidity from risk assets.

DeFi protocols freeze exposure as rsETH spreads risk everywhere

The issue got worse because rsETH is plugged into too many places. This token is wired into lending markets, yield strategies, and leveraged loops across DeFi. On X, Ignas described the exploit as “terrible due to extensive DeFi integrations” and that the full exposure is still unclear.

Aave V3 already froze its markets. SparkLend also shut down the rsETH market. Fluid froze activity as well. Upshift paused both High Growth ETH and Kelp Gain vaults. Lido Earn through the Mellow strategy meta-vault is involved, and that setup likely included leverage.

Pendle PT and YT tokens are also tied into this structure. Compound and Euler are part of the wider network, and some Beefy strategies may be affected too, with possible exposure through Yearn.

Ignas also pointed out that LayerZero could be affected because rsETH was bridged from L2 networks. That raises a direct problem. If rsETH is stuck or broken on L2s, those tokens might not hold real value right now.

He added that the situation is still developing and said he didn’t want to spread fear, but also made it clear there are “not many places to hide in DeFi” during events like this.

Former Euler Labs exec explains how losses, liquidations, and bad debt can spiral

Euler Labs’ former CEO Michael Bentley said, “The fallout from the Kelp rsETH exploit is going to be messy and could potentially be quite a bit more severe than some people are making out right now.”

He explained that rsETH on mainnet may still be backed, but there is no liquidity to sell it, and with contracts paused, “there’s currently no usable redemption path either.”

Michael ran the numbers too. If losses were spread across all holders, rsETH would sit around 81.25% of its original value based on a $300 million loss against $1.6 billion.

But he made it clear that this approach is unlikely, saying that it “would likely push a number of large positions on Aave towards undercollateralisation and risk creating bad debt,” which could trigger legal battles.

Michael also said L2 holders will probably take the hit instead. He questioned who these holders are and pointed out they could be DAOs or funds now sitting on major losses. He added that affected users may try legal action to force shared losses, which could delay redemptions even further.

Michael said once redemptions reopen, lending platforms are unlikely to accept rsETH as collateral again. That means a massive unwind of rsETH and ETH looping trades.

Right now, those trades are already bleeding. Aave ETH utilization is at 100%, borrowing costs sit at 8.71%, and staked ETH yields are around 2.5%. That puts returns deep in negative territory, ranging from about -6.21% to as low as -90%.

Michael explained that the normal unwind process, which involves swapping collateral and repaying debt, may not work at this scale. Without enough liquidity, traders may have to manually unwind step by step. 

Michael added, “If rsETH is no longer collateral and no longer has borrowing power, this makes it much more difficult for people to manually unwind as well.”

If positions stay stuck while interest builds, equity gets wiped out. Once debt grows beyond recoverable collateral, bad debt forms and keeps growing.

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