Summary
This proposal aims to optimize the Ethereum Lido market by adjusting the E-Mode parameters for WETH and wstETH, specifically addressing the issue of WETH-WETH looping positions.
Motivation
The primary motivation behind this proposal is to enhance the long-term efficiency of the Lido Instance by discouraging WETH-WETH looping positions that diminish the effectiveness of liquidity incentives. Approximately 10% of the current WETH supply in the Lido Instance is currently engaged in WETH-WETH looping, and these positions, driven by market participants’ farming incentives, undermine the intended utility of the market.
Moreover, an abrupt removal of WETH as collateral from E-Mode would result in the immediate liquidation of looping positions. While we estimate the total amount of potential liquidation would have been ~$30M, the amount of bad debt that would have been generated from this event would have been 0$, as none of the positions exceed 1 / (1 + WETH liquidation bonus). The proposed changes ensure that these loopers are given the time to manually unwind their positions and that they are transitioned out of E-Mode in a way that prevents them from suffering significant losses during liquidation.
The plan includes transitioning these positions into standard market conditions while minimizing losses through technical adjustments to the Liquidation Bonus.
Plan Overview
Below are the detailed steps for this migration process:
- Give time to deleverage
Until this AIP passes, users will have sufficient time to manually deleverage their positions, minimizing the need for liquidations. - Reduce the Liquidation Bonus of WETH outside of E-Mode
The purpose of this change is to reduce the losses faced by looping positions in the event of liquidation. The Liquidation Bonus will be adjusted to a level that provides adequate incentives for liquidators while helping loopers limit their losses if they don’t take steps to unwind their positions proactively. - Remove WETH from E-Mode Collateral
As outlined in this post, this change enhances market efficiency and optimizes the allocation of incentives. This transition will move WETH-WETH loopers to the Lido standard market, causing them to be liquidated but with minimal loss due to the aforementioned adjustment in the Liquidation Bonus. - Restore the Liquidation Bonus
Once looping positions have been fully deleveraged, restore the Liquidation Bonus to its previous level to maintain efficient future liquidations. - Increase LTV of WETH outside of E-Mode
Following the restoration of the Liquidation Bonus, raise the LTV for WETH in the Lido instance to improve composability and facilitate stablecoin borrowing.
Time to Deleverage
A substantial portion of WETH/WETH looping positions operate with very high leverage, meaning they would face immediate liquidation if transferred outside of E-Mode.
To address this, users will have until this AIP passes to manually deleverage to levels that would avoid liquidation under the standard Lido instance parameters, which has an LT of 83%.
We estimate that forced transitions out of E-Mode could trigger approximately $30M in liquidations. However, given the high leverage of these positions, the actual net value of collateral liquidated would be considerably lower, around $1.9M.
Reduce the Liquidation Bonus
Upon the passing of this AIP, we recommend reducing the Liquidation Bonus for WETH to 0.1% outside of E-Mode in the Lido instance. This adjustment minimizes the impact on users in the event of liquidation, allowing them to retain most of their initial collateral value. Rather than resulting in full liquidation, this effectively enforces a controlled deleveraging.
This approach is feasible because no positions are currently borrowing USDS or USDC against WETH in the Lido instance, as WETH’s LTV is set to 0. Therefore, the reduced Liquidation Bonus does not introduce any additional risk for standard liquidations.
Remove WETH from E-Mode Collateral
Alongside the adjustment to the Liquidation Bonus, the next component is the removal of WETH as an eligible collateral asset through the conversion to Liquid E-Mode for the wstETH/WETH pair. This change will transition all WETH-WETH looping positions into the standard Lido market, initiating a controlled deleveraging process. We estimate that the aggregate cost of deleveraging these users could be up to $32.5K, representing approximately 1.6% of users’ initial collateral. This figure assumes that no users manually deleverage their positions during the week preceding this adjustment.
Restore Liquidation Bonus and Increase LTV
Once all looping positions have been properly managed, the Liquidation Bonus will be restored to its original value, and the LTV for WETH outside of E-Mode will be adjusted to facilitate efficient stablecoin borrowing by WETH suppliers within the Lido instance. Restoring the Liquidation Bonus will ensure that future liquidations proceed smoothly and securely. The upcoming proposal will specify the new LTV, aimed at enhancing WETH’s utility as collateral and improving the attractiveness of WETH supply in the Lido instance through increased composability.
Specifications
Based on the analysis above, we recommend implementing the following specifications for each step:
Reduce the Liquidation Bonus in non E-Mode
| Market | E-Mode | Asset | Parameter | Current Value | Recommended Value |
|---|---|---|---|---|---|
| Ethereum Lido | - | WETH | Liquidation Bonus | 5.00% | 0.10% |
Remove WETH from E-Mode Collateral
| Market | E-Mode | Asset | Parameter | Current Value | Recommended Value |
|---|---|---|---|---|---|
| Ethereum Lido | E-mode1 wstETH/WETH | WETH | Collateral Enabled | Yes | No |
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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