Summary
LlamaRisk supports raising the Slope1 for all stablecoins to 9.5%. This will likely stabilize borrow rates and more accurately compensate lenders for risk. It should also increase revenue generation both for the DAO and stablecoin suppliers. Given current market conditions, it comes with growth-focused risks that may or may not materialize. The outcome will reflect wider lending market rates.
Proposal purpose
@ACI proposes raising Slope1 for all stablecoins on Aave to 9.5% to increase efficiency in protocol operations and more accurately compensate stablecoin lenders for risk.
This interest rate slope increase should also decrease interest rate volatility, increasing certainty for borrowers. It is also likely to increase protocol revenue, stemming from increased interest paid by borrowers (and, therefore, increased total amount earned through reserve factors).
Source: AaveScan USDC Borrow Rates, November 29th, 2024
This is done against some of the recent high demand for stablecoin borrowing. Interest rate spikes (stemming from periods of borrow demand being unmet by supply demand) have become increasingly frequent since October 2024. These spikes lead to higher interest rate volatility, which reduces profitability and stability for borrowers and makes it harder for depositors to estimate their earnings accurately.
Potential effects of raising Slope1
Increased interest rates
Inspecting potential borrow rate changes on Main Instance, it can be observed that at current utilization rates (as of November 30, 2024, 15:00 UTC), most stablecoins would be impacted with an increase of 4% in borrow rates.
Borrow Rate Changes for Mainnet Core Major Stablecoins, Source: LlamaRisk, calculated on November 30, 2024
Nonetheless, due to a different interest rate model where the base rate is non-zero for some stablecoins but the Slope1 is very low, this change would affect the borrow rates for such stablecoins more aggressively. The changes would then help to unify borrow interest rates. For example, USDS on Mainnet has a Slope1 of 0.75% and a Base Borrow Rate of 6.25%. Due to this setup, the current borrow rate of USDS at 88% of utilization remains significantly lower than that of other major stablecoins. This problem would be addressed with the proposed change.
In addition, some stablecoins would be impacted minimally due to the current Slope1 parameter already being high. An example could be USDe on the Main instance (current Slope1 of 9%) or USDC on Polygon (Current Slope1 of 10%), for which the borrowing rate would be negatively impacted.
These changes would largely unify the borrowing utility of each stablecoin across different Aave Markets. It would not affect the borrowing rates critically or cause imminent liquidations for the borrowers.
Increased stablecoin supply
With these increased interest rates, additional stablecoin supply would be brought to the protocol from those attracted by the stability of these higher rates. Given that this slope is substantially higher than rates available with traditional financial instruments for a relatively simple, low-risk DeFi strategy, the resulting increase in supply may be significant.
This would increase stablecoin borrow utilization (until demand follows), stabilizing the borrow/supply rates. This could result in increased borrowing demand stemming from greater market liquidity.
Interest rate stability
By pushing this Slope1 further in line with market rates, interest rates will be more reliable and stable. The spiking rates noted above will decrease in frequency as the general predictability of these rates will increase. This will compound the above-increased stablecoin supply as suppliers can rely on potential earnings to engage in activity with inherent risk.
Increased protocol revenue
As borrowers pay more to lenders, Aave’s protocol will earn more from its reserve factor on stablecoins. LlamaRisk has calculated provisional increases in revenue (if current conditions hold) of up to an additional 51% above current earnings from the increased Slope1 rate from the Mainnet Core instance alone.
Source: Estimated Rate and Revenue Changes on Mainnet Core Large Stablecoins Annualized, LlamaRisk, calculated November 30, 2024
Potential risks of raising Slope1
While LlamaRisk estimates that the risk profile of the protocol due to these changes would remain unchanged, growth-related impacts need to be considered.
Decreased demand for borrowing
As interest paid by borrowers increases, demand for borrowing reduces. This is because it becomes more expensive to acquire capital. If this interest rate becomes so high, borrowers may stop additional borrowing or choose an alternative money market with lower interest rates. This could decrease TVL and Aave’s revenue.
This risk should be situated against the wider backdrop of interest rates. Vaults.fyi DeFi-wide benchmark rates for stablecoins is currently 8.6% (and is a function of Compound, Aave and Sky rates). This should be tempered against a backdrop of high demand for leverage across DeFi, which will likely stay the same as soon as this cycle develops.
Recommendation
LlamaRisk finds this a prudent modification to make. We fully support it and will continue to monitor it on behalf of Aave DAO. Indeed, we may support a further increase in this parameter pending current conditions.
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.
