[ARFC] Interest Rate Parameter Adjustments on Prime Instance

[ChaosLabs]

Summary

With this publication, Chaos Labs proposes reducing the Slope2 parameter and increasing the UOptimal of WETH on Aave V3 Prime instance. Furthermore, we use this publication to inform and explain the recent increase of the Slope1 parameter by 40 bps for the same asset.

Borrow Rate

Following the process detailed in the AGRS Dynamic WETH Borrowing Rates, Chaos Labs executed an increase of 40bps to the WETH Slope1 on the Lido instance, implemented as a result of consistently elevated wstETH supply rates. The increase in WETH Slope 1 has resulted in a current borrow rate of 3.30%, which is compensated by the 1.10% wstETH supply rate, reaching a net borrow cost of 2.20%. This is well within the 2.70% profitability target required for Lido yield leveraging.

While the wstETH borrow rate is expected to decrease following the Prime & Core Instance wstETH Reserve Update, we expect the changes to not disrupt the market’s profitability.

Slope 2 and UOptimal

The WETH reserve has frequently exceeded 90% utilization in recent data, driven by rapid increases in borrow demand stemming from elevated wstETH supply rates. These spikes in utilization have pushed the borrowing rate into the Slope 2 range, leading to significant volatility that disrupts market stability.

To mitigate this, we propose two key changes:

• Reducing Slope 2 from 70% to 20%
• Increasing UOptimal from 90% to 92%.

Lowering Slope 2 will moderate the rate at which borrowing costs increase once utilization surpasses UOptimal, creating a more predictable borrowing environment during high-demand periods. At the same time, increasing UOptimal to 92% provides a larger buffer before Slope 2 is triggered, accommodating greater utilization while maintaining stability.

This adjustment is possible thanks to WETH’s current status as a non-collateral asset, which reduces the necessity for withdrawal liquidity during liquidation events; hence, this change presents minimal risk.

The combined effect of reducing Slope 2 and raising UOptimal is expected to create a more stable borrowing environment for WETH. Given the recent increase in WETH borrow rates due to the Slope 1 adjustment, utilization is not expected to cross 92% under current market conditions.

Specifications

We recommend the following parameter adjustments for the WETH reserve on the Prime instance:

Parameter	Current Value	Proposed Value
Slope 2	70.00%	20.00%
UOptimal	90.00%	92.00%

Disclaimer

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

Copyright

Copyright and related rights waived via CC0

[TokenLogic]

We welcome the increase in Uoptimal and reduction in Slope2 parameter which increase the capital efficiency of the wETH Reserve on Prime.

However, we do note, that upon wETH/wETH looping positions are removed, wETH should be re-enabled as collateral. Enabling wETH as collateral prior around the time liquidity mining rewards are to finish is key for retaining the wETH deposits. Without collateral status and no LM rewards, the wETH deposits are more likely to leave Prime due to the perceived opportunity cost than if wETH can access stablecoin liquidity.

The additional 2% Uoptimal increase will be absorbed quickly, due to several teams actively looking for capacity on the Prime instance. The wstETH/wETH yield maximising looping is more economical on Prime than any other instances of Aave or other large liquidity venue in DeFi.

Even with wstETH Slope1 being reduced, the current wETH Slope1 parameter can be raised and optimised further. Another 20-30 bps increase in the wETH Slope1 parameters enables LM rewards to be lowered by a matching amount, improve the revenue being generated from the reserve, whilst still allowing Aave to offer a better yield opportunity than its competitors.

[LlamaRisk]

Summary

LlamaRisk supports this proposal. It should achieve its intended aim of creating fewer interest rate spikes, which both borrowers and suppliers value. The much less steep gradient for (Borrow APR) in the proposed slope 2 change diagram will result in a far more gradual increase in interest rate. A borrow at optimal utilization to Uoptimal +2 utilization under these new conditions will go from 4% APR to 40% instead of 4% to 80%. This should result in significantly more stability in rates.

In a period of high volatility or severe deleverage, this should lower the risk of interest rate spikes as more capital is withdrawn from Aave to repay loans elsewhere. As Slope2 comes into effect much earlier, the increased interest rate from these withdrawals will likely be much less volatile than shown in @ChaosLabs’ graph above. This should result in fewer liquidations, which, in turn, reduce volatility.

With this in mind, we also welcome @TokenLogic’s suggestion to re-enable WETH as collateral in the Prime instance. WETH is currently the only collateral on Prime’s ETH-correlated E-mode. By adding additional use cases for WETH in the form of enabling stablecoin borrows, the primary risk will be increased leverage ratios throughout Aave. This may result in volatility being amplified once again in times of high price instability. This effect could be reduced by introducing a WETH-Stable Prime Emode with clearer restrictions on which stables may be used.

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.