Summary
Following the proposal to increase supply cap preferences to 90% of the total chain supply for Liquid Staking Tokens (LSTs) and Liquid Re-staking Tokens (LRTs), LlamaRisk has conducted an analysis focusing on the Base and Scroll networks, where weETH and wstETH have high supply concentration ratios. The key findings are:
- Aave’s supply caps drive the growth of LST assets on these networks, with Aave’s dominance temporarily increasing after raising supply caps but then typically decreasing as LST supply moves to other protocols.
- Sufficient on-chain liquidity is crucial for initiating liquidations and capitalizing on liquidation discounts. Current Base and Scroll liquidity is sufficient based on at-risk collateral and past liquidation data.
- To be more conservative, DEX pools should be monitored to ensure the supply cap does not exceed 2x the liquidity available within the liquidation bonus slippage.
- Proactive monitoring and measures are recommended, including:
- Ensuring sufficient liquidity before raising supply caps on heavily concentrated LST assets, as estimated via the liquidity target formula.
- Monitoring liquidity-to-supply ratios after aggressive supply cap increases to ensure stability.
- Incentivizing liquidity bridging on the L2 network when liquidity falls below targets or adjusting supply caps and other parameters to make the LST collateral less attractive.
- Maintaining Aave’s dominance below critical levels (>0.95) to ensure sustainable network growth.
Future research will focus on assessing the feasibility and impact of cross-chain liquidity on liquidations, developing agent-based simulations to model MEV actors, and investigating the implications of relying on cross-chain liquidity for L2 liquidations.
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Introduction
This note follows the Aave community proposal that increased the supply cap preferences to 90% of the total chain supply for Liquid Staking Tokens (LSTs) and Liquid Re-staking Tokens (LRTs). LlamaRisk has provided an initial note on the governance forum, covering an overview of the risks associated with this proposal.
Although the risk profile was considered to change insignificantly in the face of more drastic supply caps, LlamaRisk aimed to further research liquidity needs and liquidator response times in L2 markets, proposing proactive measures to mitigate risks and support smaller Aave markets’ confident and sustainable scaling.
This second note focuses on the two Aave markets with the highest LST supply ratios: Base and Scroll, where:
- weETH supply on Base is at ~84% of all supply
- wstETH supply on the Scroll market is at 71% of the supply
Dominance of Supply
Aave’s Influence on In-Network Supply
As initially suggested, Aave attracts demand and newly bridged assets as supply caps on these smaller markets are increased. Consequently, Aave drives the growth of its new markets and contributes to the overall asset supplies on these networks.
On-chain data confirms this claim, indicating a clear correlation between LST supply caps on Aave and overall LST supply on Base and Scroll.
Source: Dune
Source: Dune
Therefore, Aave’s proposal to enable LST leverage looping provides a clear incentive for users to bridge LST assets to these networks.
Aave’s Influence on Overall Network Activity
In addition to Aave’s dominance, we are also interested in the consequences of increasing the supply cap. Specifically, we aim to understand whether bridged supply remains solely in Aave or is distributed to other protocols, increasing on-chain liquidity without further amplifying Aave’s market dominance.
The following graphs for Base and Scroll chains indicate that Aave’s dominance increases immediately after a supply cap increase but starts decreasing within a few days, resulting in a larger TVL of LSTs in other protocols.
Source: Dune
While on Base, the supply ratio always retracts after sharp increases, on Scroll wstETH, supply ratio reduction is currently slower than historically, decreasing by 2% after the last hike and a peak of 89% one week ago.
Source: Dune
These findings suggest that such supply cap increases do not lead to a persistent rise in Aave’s dominance but instead support the long-term growth of these networks by encouraging the distribution of supply to other protocols. This data further supports the rationale behind aggressive supply cap adjustments.
Liquidity
The high concentration of LST supply on Aave necessitates sufficient liquidity for both borrowed and collateral assets to enable users to perform liquidations efficiently. More precisely, a borrowed asset is needed to initiate the liquidation, and the collateral asset of a liquidatable debt position is received at a discount. From the liquidator’s perspective, collateral assets must be exchanged (or redeemed for ETH in the case of LSTs) to capitalize on the discount and profitably finalize the liquidation.
Liquidity Need for Liquidations
Let’s illustrate a classical borrow position example when LST leverage looping is performed: a debt position on Base where 700 WETH are borrowed using 900 weETH as collateral. Suppose this position needs to be fully liquidated. If the liquidator does not directly possess the required 700 WETH, it can be acquired in the following ways:
- Using DEX liquidity on Base to swap other assets for WETH
- Bridging WETH from the mainnet
- Taking a flashloan in WETH
Then, WETH is used to repay the debt and, in turn, receive discounted weETH collateral. After receiving weETH, the liquidator needs to swap weETH for WETH (or redeem it for ETH) to capitalize on the discount. This can be done by:
- Using weETH/WETH DEX liquidity on Base
- Bridging weETH to the mainnet and exchanging weETH there
However, if the WETH was acquired using flashloans, the only possibility is to use DEX liquidity on Base. Moreover, bridging weETH to the mainnet may take significant time, exposing the liquidator to the risk of losing the discount during volatile market conditions.
Therefore, this example demonstrates that having adequate available on-chain (L2) liquidity is highly preferable and crucial for efficiently executing liquidations.
Liquidity on Base
DEX liquidity for weETH on the Base network is currently $7.8M, with a weETH share of $3.5M. All liquidity pools are weETH/WETH, which is a suitable pair for the above-described LST liquidations scenario.
Source: DefiLlama, August 29th, 2024
This liquidity represents 14% of the total weETH supply on the Aave Base market.
Nonetheless, the exchange rate for an asset is non-linear concerning the amount that would be sold due to slippage. Therefore, evaluating the liquidity situation by inspecting the following metric: 2x liquidity available within liquidation bonus as price impact is also important.
At the time of writing, 480 weETH (~$1.15M) could be swapped to WETH with a 7.5% liquidation bonus. It represents ~2.3% of the total weETH supply on Aave’s Base market.
Source: Odos aggregator, August 29th, 2024
Liquidity on Scroll
Liquidity on Scroll for wstETH is concentrated on Nuri DEX, where a wstETH/WETH liquidity pool with a TVL of $4M and a wstETH share of $0.3M is available, and on Ambient DEX where a wstETH/ETH liquidity pool exists with a TVL of $7.31M and wstETH share of $2.91M.
Source: Nuri exchange, 29th of August, 2024
Source: Ambient exchange, 29th of August, 2024
This liquidity represents 19.2% of the total wstETH supply on the Aave Scroll market.
3,000 wstETH ($7.9M) could be swapped to WETH with a 7.5% liquidation bonus. It represents ~13.4% of the total wstETH supply on Aave’s Scroll market.
Source: Odos aggregator, August 29th, 2024
Positions at Risk
Multiple risk factors must be considered to understand the required liquidity. Additionally, historical liquidations and current positions at risk provide a conservative estimation of LST liquidity needs.
Low Health Positions
Currently, $1.82M of wstETH collateral is at risk on Scroll, which amounts to 45% of the total wstETH liquidity on the network.
wstETH collateral at risk on Aave Scroll, Source: ChaosLabs dashboard, August 29th, 2024
In contrast, a much less tense situation can be observed with weETH collateral. Less than $50K of weETH collateral is at risk on the Base market.
weETH collateral at risk on Aave Base, Source: ChaosLabs dashboard, 29th of August, 2024
These differences indicate that the situation can vary, and needed liquidity thresholds can change drastically over time and across different markets.
Past Liquidations
Given that L2 markets are less mature, there is no extensive historical data to monitor the extent of liquidations during high-market stress periods. Nonetheless, available data can provide floor estimates of the required liquidity.
On Base, the largest one-day weETH collateralized loan liquidations were $400K during recent market stress on August 5th, 2024.
Source: Dune
On Scroll, wstETH liquidations were almost non-existent, with maximal one-day liquidations reaching only $20K.
Source: Dune
While both markets indicate no stress induced by liquidations, the data cannot conclude that liquidity needs are completely satisfied.
Other Risk Factors
In addition to collateral at risk and historical liquidations data, and more importantly, since our focus assets are LSTs, other risk factors are also significant.
Upward market price manipulations are mitigated by Aave’s CAPO mechanism that is used for all LSTs on different Aave markets; therefore, a manipulation risk is only present for a downward peg of an LST asset.
Firstly, the risk of slashing is always apparent when using LSTs as collateral. While such events are unpredictable, they would cause position liquidations on all Aave markets, making LST-to-base token liquidity scarce even on Mainnet, discounting the ability to bridge assets and perform liquidations efficiently.
Secondly, LST-to-base de-pegs may disturb the market, especially if the main use case is LST leverage looping. As this is the case for Base and Scroll, elevated caution is necessary when estimating liquidity needs.
Historically, such risks were minimal; therefore, only the general collateral at risk and the sizes of LST loan positions must be monitored to evaluate these changing risk factors.
Estimated Liquidity Coverage
Based on the analysis of positions at risk, historical liquidations, and other risk factors, it is possible to dynamically estimate the liquidity needs for each high-supply LST asset on Aave L2 markets.
The relative liquidity of an LST asset for which Aave increases the supply cap to >75% of the total on-chain supply should also grow. In that case, the liquidity-to-supply ratio should be stable or increase. This would ensure that the overall LST asset supply grows more organically and that the Aave market does not become increasingly exposed to the risk of insufficient liquidity for liquidations.
The collateral at risk metric would need to be monitored to quantify the liquidity needs and the target liquidity re-evaluated flexibly. The estimate is as follows:
The current liquidity of both weETH on Base and wstETH on Scroll remains above the target; therefore, the native chain liquidity can be deemed sufficient for both assets. However, the liquidity-to-supply ratio must be monitored after each aggressive supply cap increase.
Recommended Actions
An extensive analysis of LST liquidity needs has not indicated elevated risks on the markets and assets of interest. However, given the dynamic nature of these supply cap increases, we recommend continuously monitoring the situation and facilitating cap increases by suggesting the following actions:
- Before raising the supply caps on an LST asset that is already heavily concentrated, sufficient liquidity needs to be ensured as estimated via the liquidity target formula.
- After raising the supply caps, the liquidity-to-supply ratio needs to stabilize in the days following the supply cap increase.
- If the liquidity of a monitored high-supply asset falls below the targets, 1) bridging the liquidity needs to be incentivized on the L2 network (to be taken care of by the Aave Liquidity Committee), or 2) supply caps need to be adjusted downwards (if the supply cap has not been reached yet), and other parameters need to be adjusted to make the LST collateral less attractive.
- Aave’s dominance should be at a manageable level (>0.95) for a sustained period. Otherwise, it would mean that the effective growth of the network is sustainable.