Overview
In this proposal, we recommend adjusting parameters for weETH on the Aave v3 Scroll instance: specifically, increasing the UOptimal, decreasing the Slope 1, and increasing the borrow caps.
These changes aim to mitigate the volatility of the WETH borrow rate on the chain by enabling WETH/weETH looping to profitably arbitrage and stabilize the rate while the market reaches equilibrium.
Motivation
Following the conclusion of the Scroll airdrop campaign on October 19th, 2024, the WETH borrow demand on the chain has consistently exceeded the available supply. This sustained imbalance has caused the utilization of the WETH pool to surpass the UOptimal, introducing significant volatility in the WETH borrow rate.
It is evident that the increased WETH borrow rate, resulting from the reduced WETH supply post-airdrop, first affected the wstETH looping demand. In contrast, the weETH supply has remained mostly stable since the start of rate fluctuations. The greater stability of weETH borrows is likely attributed to its higher intrinsic APY and speculative element, allowing the strategy to remain profitable at higher average WETH borrow rates.
Since this situation is not conducive to incentivizing yield-leveraging strategies, we propose a method that enables rate arbitrageurs to profitably reduce the WETH interest rate without the necessity of attracting additional WETH supply from other chains.
This method involves reducing the weETH Slope 1 to a level where borrowing weETH against WETH collateral becomes profitable, converting the borrowed weETH back to WETH, and redeposit it into Aave. To ensure a larger buffer and enhance the effectiveness of this “inverse” looping in reducing the WETH borrow rate in the future, we also recommend increasing the UOptimal of weETH.
Slope 1 and UOptimal
To determine the optimal Slope 1 required to incentivize closing the gap through “inverse” looping, we analyzed the historical utilization of the WETH pool since the Scroll airdrop. We observed that during periods with the highest rates, the utilization was approximately 1,500 WETH above the UOptimal. Although this discrepancy has now reduced to 400 WETH, this analysis provides a baseline to gauge the minimum target increase in weETH borrows necessary to smooth the borrow rate if the supply were to return to previous levels.
From our calculations, reducing the Slope 1 of weETH to 6% and increasing the UOptimal to 45% will allow users to borrow up to 4,500 more weETH while maintaining the same average borrow cost incurred since the Scroll snapshot was taken. This provides a significant buffer over the historic need of up to 1500 weETH.
It is also important to note that, due to the underlying restaking rate of weETH at 4.25%, these changes are unlikely to affect the WETH supply and borrow rate until it exceeds that value. Therefore, we should not expect significant “inverse” looping to occur under standard market conditions.
Borrow Utilization
The three largest weETH borrowers constitute the majority of the market activity. Two users employ weETH as collateral to borrow weETH, while the third utilizes wstETH collateral to borrow weETH. Given the high correlation between the collateral and the borrowed assets, none of these top positions pose a significant liquidation risk.
Furthermore, by assessing each point on the WETH supply rate curve, we can estimate the true cost of borrowing weETH when accounting for its underlying yield. This analysis allows us to determine the amount of weETH that can be borrowed profitably for the purpose of looping and arbitraging the interest rate. Considering the average WETH supply rate recorded since the Scroll snapshot, the new parameters would permit an additional 5,300 weETH to be borrowed profitably to bridge the gap.
Following the adjustments proposed above, we also recommend increasing the borrow cap of weETH to 13,000 weETH. This increase will enable additional utilization and provide sufficient capacity in the borrow caps to accommodate higher potential borrow demand under the updated parameters.
Recommendation
Based on these considerations, the following parameters are recommended for weETH on the Aave v3 Scroll instance:
| Parameter | Current Value | Recommended Value |
|---|---|---|
| Slope1 | 8.00% | 6.00% |
| UOptimal | 30.00% | 45.00% |
| Borrow Cap | 6,400 | 13,000 |
Next Steps
- Direct to AIP process.
Disclaimer
Chaos Labs has not been compensated by any third party for publishing this ARFC.
Copyright
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