[ARFC] Chaos Labs Risk Parameter Updates - Increase Borrow caps for wstETH on the Lido Market - 10/20/24

[ChaosLabs]

Summary

In this proposal, Chaos Labs recommends increasing the borrow cap for wstETH in the Aave V3 Lido market deployment.

Motivation

With the upcoming listing of ezETH in the Aave V3 Ethereum Lido market and the introduction of an ezETH/wstETH E-Mode, Chaos Labs anticipates that ezETH’s primary use case will be as collateral for borrowing wstETH to leverage ezETH’s yield.

Though wstETH is a yield-bearing asset and typically not heavily borrowed, the current implied Pendle yield of 5.2% and underlying yield of 4.3% for ezETH make borrowing wstETH an attractive option. When the combined yield of wstETH and its borrowing cost is lower than ezETH’s overall implied yield, wstETH becomes a favorable asset to borrow for those seeking to effectively leverage ezETH’s yields.

The chart shows the ezETH implied yield in blue and the ezETH underlying yield in green.
Source: ezETH Ethereum on pendle.finance

Looping

The current low borrow cap for wstETH in the Lido market deployment is largely utilized by users looping wstETH to farm supply incentives. This strategy is only viable if wstETH borrow demand remains low enough to keep the borrow rate below the incentive APY of 0.46%.

With the listing of ezETH and anticipated increased demand for wstETH borrowing, it’s unlikely that the borrow APY for wstETH will remain low enough to make looping viable. Hence, we do not expect looping to represent a significant portion of the market.

Recommendation

While a larger borrowing buffer is beneficial in a looping market, the current wstETH supply of 120,000 provides ample available supply for borrowing without risking illiquidity.

Therefore, Chaos Labs recommends setting the borrow cap for wstETH at 14,000 to align with the LTV of ezETH, based on its recommendation for an initial supply cap. This value is derived from the proposed ezETH supply cap of 15,000 and its 93% LTV.

This borrow cap update should be implemented alongside the ezETH listing and its new liquid E-mode categories.

Specification

Chain	Asset	Current Supply Cap	Recommended Supply Cap	Current Borrow Cap	Recommended Borrow Cap
Ethereum Lido Market	wstETH	650,000	-	100	14,000

Next Steps

1. Direct to AIP process.

Disclaimer

Chaos Labs has not been compensated by any third party for publishing this ARFC.

Copyright

Copyright and related rights waived via CC0

[LlamaRisk]

Summary

LLamaRisk supports the proposal to increase the borrowing cap of wstETH on the Aave V3 LiDo instance. The incoming listing of ezETH as collateral on the Aave V3 LiDo instance will enable an ezETH/wstETH looping use-case. Increasing the wstETH borrow cap from 100 (essentially 0) to 14,000 is necessary to allow this use case.

ezETH/wstETH E-mode

As a refresher, here are the parameters proposed by @ChaosLabs for the ezETH-wstETH E-mode once ezETH is onboarded:

Parameter	Value	Value
Asset	ezETH	wstETH
Collateral	Yes	No
Borrowable	No	Yes
Max LTV	93%	93%
Liquidation Threshold	95%	95%
Liquidation Penalty	1.00%	1.00%

Source: ezETH LiDo ARFC, proposed on October 14th, 2024

The proposed increase in borrow cap from 100 wstETH to 14,000 wstETH aligns with the proposed 15,000 supply cap for ezETH and its 93% LTV. The current wstETH supply cap of 650k at 20% usage provides ample room for that 14,000 increase in borrow cap.

Source: wstETH LiDo supply utilization, October 21st, 2024

Potential for liquidity incentive mining

We agree with @ChaosLabs’s assessment that the current wstETH/wstETH looping use-case won’t be profitable and disappear once ezETH is onboarded on the Aave V3 LiDo instance as collateral. The demand for wstETH borrowing will increase the borrowing rate to unprofitable levels for mining liquidity incentives.

Regardless, a separate proposal for which we are favorable will soon disable the wstETH/wsETH and WETH/WETH looping use-cases, hence preventing liquidity incentive mining all-together.

Disclaimer

This review was independently prepared by LlamaRisk, a community-led non-profit decentralized organization funded in part by the Aave DAO. LlamaRisk is not directly affiliated with the protocol(s) reviewed in this assessment and did not receive any compensation from the protocol(s) or their affiliated entities for this work.

The information provided should not be construed as legal, financial, tax, or professional advice.

[MarcZeller]

This proposal has been bundled with [ARFC] Onboard ezETH to Aave V3 Lido Instance at the AIP implementation stage for more efficiency.