Reportedly from Woofun AI, Babylon Labs has submitted a paradigm-shifting ARFC proposal to Aave V4, aiming to use the BaBe zero-knowledge proof system to ensure that Bitcoin remains in the owner's wallet throughout the collateralized lending process, thereby completely breaking the custody trust dilemma that has long plagued the industry.
For a long time, as the largest collateral by volume among crypto assets, Bitcoin has faced a structural contradiction in DeFi lending: control must be handed over. Of the 20.1 million Bitcoin already mined, only 1.7% exists in token form on other blockchains, and almost every underlying Bitcoin is held by a custodian or a signer group. Yet holders' demand for such lending remains strong. Coinbase (COIN.US) connected its Bitcoin-collateralized lending business to a market on the lending protocol Morpho; in the year ended September 30, USDC lending in that market grew 74.9% to $1.5 billion.
On October 14, Babylon Labs formally submitted an ARFC proposal requesting that Aave V4 support native Bitcoin held in the owner's Bitcoin Output as collateral. The core of the mechanism is that as long as there is one honest challenger, malicious withdrawals can be prevented, and the Bitcoin holder himself can serve in that role. Aave voters passed the temperature check vote with 299,743 AAVE in favor and 0 against, marking that this innovative mechanism is about to enter the Snapshot voting stage.
From the perspective of comparing trust assumptions, the Babylon vault reduces the trust threshold required by borrowers to a single honest party. By comparison, WBTC's custodian uses 2/3 multisig to manage its reserves, tBTC requires 51 of 100 signer seats to transfer tokens, and LBTC relies on 10 of 14 consortium members. The Babylon vault requires only a single honest challenger, and that role can be filled entirely by the holder himself. This simplification of the trust model fundamentally eliminates dependence on centralized custodians or multisig alliances, returning asset control to users.
Technological innovation is the key to making this proposal feasible. Under the BaBe system, the dispute resolution cost on the Bitcoin chain is only $37.82, compared with $14,211 for BitVM2. This proof system developed by Babylon Labs will be presented at the ACM CCS 2026 conference, and it also sharply reduces the initialization setup data for each vault from 40.5 GiB to 22.2 MiB. This breakthrough was jointly completed by researchers from Babylon Labs, the University of California, Berkeley, and Stanford University. The BaBe system, built on Witness Encryption, not only keeps dispute costs at an ultra-low level of about $38, but also slashes that data volume by 1,868 times, solving the huge storage and cost bottlenecks of previous technical solutions.
Looking back at the historical background, the reason Bitcoin previously had to rely on custody stems from the limitations of its scripting language. Bitcoin Script can verify signatures, hashes, and timelocks, but it cannot directly verify zero-knowledge proofs, nor can it read the state of other blockchains. Writing a proof verifier in Bitcoin Script would require about 900 MB of block space per proof, equivalent to the capacity of 225 full blocks. For this reason, Bitcoin in DeFi has always needed some entity to hold it on behalf of others: a custodian, a signer group, or a consortium that signs a release transaction after the loan is repaid. BitVM, released in October 2023, moved the verification process off-chain, making a claim valid by default unless someone proves it false. BitVM2, launched in August 2024, reduced the trust required for cross-chain bridges to a single honest party, although a single dispute costs $14,211 in fees and relies on non-standard transactions that the vast majority of Bitcoin nodes will not relay. BitVM3 used Garbled Circuits to reduce dispute costs to $37.65, but each vault still needed to store 40.5 GiB of initialization setup data. The emergence of BaBe finally achieved a dual breakthrough in cost and efficiency in this series of technological evolutions.
Woofun AI compiled data showing that, in terms of operating mechanism, the Babylon vault builds this proof system around a single owner's tokens. Before the Bitcoin is locked, all participants pre-sign all possible directions the Bitcoin may take: refunds, withdrawals, liquidation claims, and challenges. Subsequently, the Bitcoin network only accepts these pre-signed operation paths. A claim on that Bitcoin must include a valid proof and must go through a challenge window lasting several days. During that window, the vault provider, application Keepers, a general challenger, or the Bitcoin holder himself can step in to stop malicious claims. Since launching on Ethereum on March 30, Aave V4 has divided lending into Hubs that hold liquidity and Spokes that set specific rules for various borrowers. This ARFC proposal adds two new Spokes. Among them, the Babylon Spoke, written by Aave Labs, is a derivative of Aave's standard Spoke and uses native Bitcoin as its only collateral. Aave had previously launched the LBTC Spoke, and Babylon's proposal will become the first Spoke for unwrapped native Bitcoin. Stani Kulechov called this dedicated Bitcoin hub "exactly the use case the V4 architecture was built for."
Asset owners lock BTC in a Taproot output on the Bitcoin network, and then an adapter on Ethereum records it as a credential token that has no administrator, is non-transferable, non-tradable, and non-upgradeable. The owner then borrows stablecoins from the Hub and pays Aave's benchmark interest rate plus a Babylon interest fee, the rate for which has not yet been set in the ARFC proposal. The liquidation mechanism brings Aave a second interest income stream. If a position's Health Factor, the metric Aave uses to measure the ratio of collateral to debt, falls below 1, liquidators will repay the debt and seize the entire vault. The Swap Spoke buys the vault at a discount below the oracle price and uses WBTC borrowed from the Hub to pay liquidators; authorized arbitrageurs then repay the WBTC and redeem the Bitcoin from the Bitcoin network within a few days. Because borrowers had drawn only 2.10% of the 34,545 WBTC supplied on Aave V3 Ethereum as of September 30, compared with 14.6% in May 2024, this lending model makes full use of reserve pools with ample surplus liquidity.
For institutional investors, this mechanism provides the dual value of balance sheet retention and interest rate advantages. Institutional investors have long financed assets in similar ways. In Tri-party repo transactions, collateral remains with a custodian trusted by both parties while the lender holds an enforceable claim; the Babylon vault preserves this structure, except that Bitcoin Script serves as the custody agent and the custodian is the asset owner himself. Fisher Yu described it as "Bitcoin that does not leave the owner's possession, balance sheet, or national borders," and HashKey Cloud plans to let institutional clients in Asia borrow through these vaults using native Bitcoin as collateral and put the borrowed stablecoins into various yield strategies.
The pricing of borrowing has also ushered in innovation. Bitcoin lender Ledn publishes annual loan rates ranging from 11.49% for loan sizes below $250,000 to 9.25% for large loans of $2 million and above. In the 30 days ended September 30, the average annualized USDC lending rate on Aave V3 was only 4.64%, and a uniform rate applied regardless of loan size. Babylon expects the annualized cost of vault borrowing to be between 3% and 5%, and plans to charge a 0% vault protocol fee in the initial launch period.
On risk avoidance, institutions' strong demand for decentralized self-custody lending stems from painful historical losses that coin holders still remember vividly. Previously, the lending platform BlockFi lent customers' crypto assets to institutional borrowers, while Genesis lent crypto assets from the Gemini (GEMI.US) Earn program, and both platforms declared bankruptcy before January 2023. When custodian BitGo (BTGO.US) migrated WBTC custody to a joint venture with BiT Global in August 2024, stablecoin issuer Sky immediately voted to cut its WBTC borrowing cap to zero. As of October 20, WBTC reserves held 116,512 BTC, down 25% from 154,707 on the day the custody change was announced. With the Babylon vault, what asset allocators focus on is no longer the fragile balance sheet risk of custodians, but a transparent on-chain exit mechanism. After a challenge window lasting several days, Bitcoin can be returned along the original path. The vault contract on Ethereum can be immediately paused by two multisig mechanisms: a 4/7-seat Interim Governance multisig and a 3/5-seat Emergency Guardian multisig that includes seats for Aave Labs and LlamaRisk. The Emergency Guardian can independently lift the pause, while contract upgrades have a 5-day timelock. Aave's risk service providers will set borrowing caps and LTV before the on-chain vote.
In terms of the revenue distribution model and token economics, the ARFC proposal finely allocates eligible revenue: revenue sources include the Hub Liquidity Fee extracted from interest paid by Babylon Spoke borrowers, as well as fees generated from liquidations. The remaining interest paid by borrowers is distributed directly to Hub liquidity providers. Aave exclusively receives the first $500,000 of revenue each year. The excess is split according to tiered brackets, with Babylon's share rising from 18% to 31.5%, and an additional 4% to 7% of revenue used to buy back AAVE and BABY tokens in the open market, of which 85% is AAVE, with the repurchased tokens split equally between the Aave DAO and the Babylon Foundation. For BABY token holders, these vaults open the first direct channel from borrower interest to token value capture. When eligible annual revenue reaches $10 million, the buyback share will purchase $84,000 of BABY each year, while Babylon's own protocol revenue share is even more substantial; Babylon plans to launch a new plan in January to reduce inflation and guide token emissions toward vault usage. Since December 1, 2025, BABY has cumulatively fallen 37.1%, compared with a 9.2% decline in BTC and a 14.6% decline in AAVE. BABY currently corresponds to a circulating market value of about $60.4 million, in sharp contrast with the 40,843 BTC staked on the Babylon protocol.
Regarding the implementation path, revenue projections, and future outlook, since the proposal was published on October 14, Stani Kulechov and other community members have given firm support to the ARFC, and Babylon also responded quickly within 10 hours, answering core questions about the vault's pause authority. So far this year, Aave voters have passed 73 of 74 yes-or-no Snapshot proposals. According to the Aave governance framework, four standardized steps are still required before mainnet launch: risk and technical review, in which LlamaRisk publishes a risk assessment report in the forum and Aave Labs publishes a technical assessment report, a hard prerequisite before Snapshot voting for new assets under the framework Aave adopted in August; Snapshot voting, with a 1-day delay period and a 3-day community vote, requiring a quorum of 320,000 AAVE; an on-chain AIP proposal, formally establishing parameters such as borrowing caps and LTV, followed by a 1-day delay period, a 3-day on-chain vote, and a 1-day timelock execution period; re-audit and phased launch. Coinspect, Sherlock, Zellic, ABDK, ZK Security, and Runtime Verification had previously conducted multiple rounds of audits on the vault code, and Sherlock reported 8 high-severity and 55 medium-severity issues, all of which have been fully resolved or acknowledged. Coinspect, ABDK, and Zellic will re-review the final code changes before mainnet launch. Mainnet will adopt a conservative phased rollout with initial caps; the previous December plan had targeted mainnet launch in April. Assuming vault lending volume reaches the scale Coinbase had as of September 30, that is, $1.5 billion borrowed at a 4% rate, which happens to fall at the midpoint of Babylon's expected 3% to 5% range, then at a 10% to 20% liquidity fee rate, it would generate $6 million to $12 million in eligible revenue each year. In Aave V4, its Core Hub charges a 10% liquidity fee on USDC, the Plus Hub charges 15%, and the Core Hub charges 20% on USDG; the ARFC proposal leaves the decision on which Hub the Babylon Spoke specifically connects to for a subsequent AIP proposal. In a scenario where annual eligible revenue reaches $6 million, the Aave DAO can retain about $4.5 million each year, Babylon receives about $1.3 million, and another $280,000 is used to buy back AAVE and BABY. If annual revenue reaches $12 million, those figures jump to $8.2 million, $3.2 million, and $700,000, respectively. Under a 50% LTV assumption, $1.5 billion in lending volume would require roughly 36,800 BTC of collateral at October 20 prices, comparable to Babylon's current total staked scale of 40,843 BTC, although staking for yield and vault collateralized lending are two different use cases for the token. This is a key breakthrough in trust minimization and cost efficiency for native Bitcoin DeFi following the BitVM series of technological explorations, and is expected to reshape the infrastructure landscape for institutional-grade Bitcoin liquidity.
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