Summary
We support removing the supply cap limit on LST/LRT, acknowledging that ongoing monitoring is crucial. Our research indicates that Aave is a key demand and growth driver on networks like Base and Scroll by encouraging asset bridging. Although high supply concentration on Aave can hinder effective (profitable) liquidations, we’ve observed that some bridged liquidity eventually reaches other protocols, leading to a healthier overall supply distribution.
Strategically increasing LST supply caps is advisable for ensuring both market growth and network growth for less mature L2 markets. However, it requires robust safeguards from risk service providers to mitigate potential systemic risks from supply dominance and liquidity constraints. If liquidity metrics fall below safe thresholds, incentives could be considered to attract more liquidity. The Aave Liquidity Committee (ALC) should assess the costs of such incentives separately and execute them if necessary.
By closely monitoring liquidity and supply dominance, this strategy can enable the safe scaling of smaller Aave markets without compromising the overall risk profile. We are developing tools to monitor real-time liquidity and have proposed a methodology to assess liquidity health for these specific assets.
Detailed research below
Introduction
This ARFC proposal can be justified based on the research conducted by LlamaRisk related to Aave’s supply caps dominance. The research suggested that Aave serves as a key demand and growth driver on networks such as Base and Scroll by encouraging supply growth through higher supply cap allowances.
This strategic move of increasing supply caps on LSTs is valuable for ensuring both market growth and overall network growth for less mature L2 markets. However, it requires robust safeguards from risk service providers to avoid potential systemic risks from supply dominance and liquidity constraints.
Findings
The analysis highlighted the relevance of this issue in markets like Base and Scroll, where LSTs such as weETH and wstETH represent a significant proportion of the total supply. On Base, for instance, the current supply cap ratio for weETH is around 84%, while for wstETH on Scroll, it’s 71%. This concentration calls for careful liquidity management to ensure the markets remain healthy and stable.
Liquidity limitations are a key factor here. While the liquidity-to-supply ratio can decrease sharply following a supply cap increase, cross-chain bridging can mitigate these limitations to some extent by enabling assets to be transferred between Mainnet and L2 networks to ensure needed liquidity on-demand. However, such reliance adds complexity to liquidations and increases exposure to volatility.
Based on the analysis, we believe that removing supply cap preferences would not alter the overall risk profile, and the findings of this research still hold. Temporary spikes in market dominance (>95%) are likely but are typically expected to retract within a 2-3 day period, allowing the network to self-regulate without triggering excessive risk.
Monitoring
Nonetheless, to ensure the safe scaling of supply caps, continuous monitoring is critical. Three key metrics should be tracked to maintain market stability:
- Liquidity within the liquidation bonus slippage: The liquidity needed to cover liquidations without causing excessive slippage and therefore perform liquidations effectively.
- Supply dominance: Ensure Aave’s share of LST supply retracts to lower levels after sharp increases.
- Positions at risk: Track the volume of LST collateral at risk for liquidation (low-health positions).
To quantify a baseline liquidity size needed, the following liquidity baseline metric would be used for less mature L2 markets:
This dynamic metric consists of two components:
- Maximal Collateral at Risk for an LST asset over the last 30 days. The Collateral at Risk metric represents the total amount of collateral tied to debt positions with low health in a specific market. This metric would provide proactive warning about declining health of LST asset loans.
- Maximal historical liquidations of LST asset collateral. Since L2 markets are less than one year old, no extensive market stress was observed. Therefore, it is crucial to ensure that liquidity is enough at least for the worst that has happened historically on that market.
This soft liquidity threshold estimate would be a red flag indicator for insufficient liquidity. Nonetheless, other metrics would provide more conservative liquidity coverage estimations.
LlamaRisk will develop the necessary tooling to continuously monitor these metrics, providing proactive alerts when the liquidity or supply dominance approaches critical thresholds.
Disclaimer
This review was independently prepared by LlamaRisk, a community-led non-profit decentralized organization funded in part by the Aave DAO.