[ARFC] Remove Community Preference For Supply Cap Limits

[ARFC] Remove Community Preference For Supply Cap Limits

Author: @ACI

Date: 2024-09-11


Summary

This proposal suggests removing the informal supply cap restriction previously set by the community in the past vote [ARFC] Increase Community Preference For Supply Cap Limits.

Motivation

Supply caps for select tokens continue to be a limiting factor on growth. After the previous community preference vote to increase soft supply cap limits to 90% of total supply, we believe further adjustments are needed and feasible within a clear risk framework.

The current paradigm of limiting supply cap growth based on total supply doesn’t take into account specific nuances of networks and the fact that Aave serves as a demand driver for supply on a network as well as further liquidity.

A good example is that Scroll borrow cost for WETH is currently 2.3%, which is lower than other networks and leaving money on the table for the DAO. There is over 10k wETH available liquidity with a utilization of 81%. Increasing the supply cap of weETH on that network and assuming 1.2 weETH per wETH borrowed means an expected inflow to Aave of 5k weETH collateral, which is a manageable adjustment.

We suggest regularly reviewing the supply and borrowing rates. If the WETH borrow is below or equal to 25 bps below the wstETH staking yield, we suggest risk stewards implement a cap raise for collateral LST/LRT such as wstETH & weETH.

Specification

We propose the community adopt the following:

  • The community preference for supply cap limits will be removed, with supply and borrow cap growth to be driven by the risk frameworks of risk service providers and strategic considerations for growth.
  • Where borrow rates on WETH are below expected market demand, increase supply caps on relevant collaterals to boost borrow rates, leading to further supply inflows for WETH.

Useful Links

[Temp Check] - Community Preference for Supply Cap Limits for LSTs

[ARFC] Increase Community Preference For Supply Cap Limits

Disclaimer

The ACI has not been compensated for the publication of this proposal.

Next Steps

  1. Publish a standard ARFC and collect community & service provider feedback before an ARFC snapshot.
  2. If the ARFC snapshot passes, this community preference becomes canon and risk service providers incorporate this into current and future recommendations.

Copyright

Copyright and related rights waived under CC0

4 Likes

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:

  1. Liquidity within the liquidation bonus slippage: The liquidity needed to cover liquidations without causing excessive slippage and therefore perform liquidations effectively.
  2. Supply dominance: Ensure Aave’s share of LST supply retracts to lower levels after sharp increases.
  3. 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:

image

This dynamic metric consists of two components:

  1. 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.
  2. 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.

2 Likes

Chaos Labs supports this proposal, finding that it provides risk providers with increased flexibility while not materially increasing risk. Regarding the first specification, we find that this will allow us to facilitate growth better while continuing to manage risk. While removing this preference will allow us to recommend increases beyond 90% of supply, we will only do so in cases where we are confident, and simulations show, that doing so will not increase the risk of loss to the Aave protocol. Regarding the second specification, we favor using the supply of LSTs and LRTs to ensure that WETH remains near UOptimal.

2 Likes

After the requisite forum discussion period, this proposal has been escalated to Snapshot stage for voting. We encourage everyone to participate.

1 Like

Just as an update, ARFC Snapshot passed, therefore the proposal had become canon and Risk Services Providers will incorporate it into future recommendations.