[ARC] Stablecoin Volatility Risk Parameter Recomendations

USDC Pause pros and cons

TLDR;

Our recommendation for all deployments currently is not to pause. With the peg restoring, we believe there is a higher risk of incurring bad debt due to non-stable (WBTC, WETH) volatility compared to the threat of a USDC/DAI depeg to 0.85 prices and below.

The inflection point of large bad debt is in the following scenarios:

  1. Unpaused: USDC/DAI reaches 0.85 prices, causing over 2 million bad debt (and a sharp bad debt accumulation thereafter)

  2. Paused Markets: Nonstables (BTC, WETH, etc.) price drops over 40%, causing over $2 million in bad debt (and sharp bad debt accumulation thereafter).

Risk Scenarios

When assessing the situation, we’re addressing the following scenarios:

  1. USDC regains its peg.
  2. USDC keeps trading around the current discount level.

These scenarios may include a momentary depeg much more significant than the current level.

We are not accounting for a scenario in which USDC completely loses its peg for 2 major reasons:

  1. We don’t identify any strong evidence to support that
  2. This would encourage decreasing USDC and DAI exposure as fast as possible, even at the cost of losses. Given that we do not see this as a likely scenario. The damage here can be greater than the reward.

Pausing Assets - Pros and Cons

We have evaluated the possibility of pausing or freezing assets to mitigate protocol risk. The main risks are listed by order of significance, 1 being the riskiest and 5 being the least risky.

For AAVE V3 Deployments:

V → No new risk introduced, subject to market movements

X → New Risk exposure due to stable depeg or new reserve configuration

Disabling stable collateral (LTV=0), Governance Vote Required Freezing Stables, Governance Vote Required Pausing Stables Pausing All
1. Toxic In-Flow Risk - New Positions (net new USDC dumped into Aave) V V V V
2. Toxic In-Flow Risk - Existing Positions X X V V
3.a. Bad Debt from Liquidations of stablecoins X X V V
3.b. Bad Debt from other assets V V V X (liquidations cannot be made as a function of market movements)
4. Leverage Increase by Collateral Withdrawals X X V V
5. Leverage Increases by increasing borrows X X X V

For AAVE V2 deployments:

Disabling stable collateral (LTV=0) Freezing Stables Pausing All
1. Toxic In-Flow Risk - New Positions (net new USDC dumped into Aave) V V V
2. Toxic In-Flow Risk - Existing Positions X X V
3.a. Bad Debt from Liquidations of stablecoins X X V
3.b. Bad Debt from other assets V V
4. Leverage Increase by Collateral Withdrawals X X V
5. Leverage Increases by increasing borrows X X V

Analysis

Markets Not Paused -Stablecoin Depeg (worst case - liquidation of entire collateral)

Markets Paused (Assuming re-peg) - Loss due to disabling Liquidations Incurred During Volatile Asset Price Crash

Recommendation

V2 Deployment

  • Don’t pause currently; continue monitoring and updating as a function of market changes.
  • Freeze stable markets, set LTV to zero

V3 Deployments

  • Don’t pause currently; continue monitoring and updating as a function of market changes.
  • Freeze Stables set LTV to zero.

It is important to note that pausing can be introduced via Admin functionality anytime. However, freezing markets requires a governance process and can take several days. Where possible (like Avalanche), we recommend freezing immediately.

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