[ARFC] Risk Parameters for DAI Update

Dear Aave Community,

As LlamaRisk continues to assess the collateral risk associated with Ethena’s USDe stablecoin, we are providing initial feedback ahead of the upcoming snapshot vote on updating DAI risk parameters. While a comprehensive risk assessment is still in progress, we share a number of concerns compiled below. Based on the analysis of these concerns, Ethena’s integration with Maker DAI does not pose an immediate systemic risk for Aave.

  1. High Collateral Concentration and Transparency Concerns: A significant portion of Ethena’s collateral is concentrated on centralized exchanges, particularly Binance, exposing the protocol to increased counterparty risks. Moreover, Ethena’s collateral is held by a few custodians, including Copper, Cobo and Ceffu. Greater transparency regarding verifiable collateral balances vs. circulating USDe would help assess overall risk.
    Source: Ethena, April 7th, 2024
  2. Effectiveness of Delta-Neutral Hedging: Limited liquidity on centralized exchanges could pose significant challenges, particularly during market stress or volatility. If Ethena needs to execute large trades to maintain its delta-neutral positions or manage collateral, the lack of liquidity could result in substantial slippage and unfavorable execution prices. As Schmeling, Schrimpf, and Todorov (2023) highlight, the crypto futures basis (or “crypto carry”) can become very large and vary strongly over time due to the interplay between trend-chasing retail investors and the relative scarcity of arbitrage capital. During market downturns, this dynamic can lead to a breakdown in the effectiveness of delta-neutral hedging strategies. The effectiveness of Ethena’s approach relies on several factors:
    • Accurate pricing data: The hedging positions must be based on reliable and up-to-date price information to ensure proper alignment with the collateral’s value.
    • Efficient execution: Ethena needs to execute the necessary trades efficiently to maintain the delta-neutral position, minimizing slippage and transaction costs.
    • Sufficient market liquidity: The futures markets used for hedging must have adequate liquidity to absorb Ethena’s trades without significant price impact.
    • Management of funding rates: Perpetual futures contracts are subject to funding rates, which can impact the cost of maintaining the hedging positions. Negative funding rates could lead to a liquidity crunch and mass sell-off, threatening the stability of the peg.
  3. Underfunded Insurance Fund: Ethena’s insurance fund appears underfunded relative to the protocol’s scale. Based on Chaos Lab’s research of Nov. 2023 (Perpetual Future, Liquidity and Funding Rate Considerations for Ethena), during the most significant funding rate inversion event in the past three years (The Merge, September 2022), Ethena could have faced losses of up to 4.3% due to a prolonged negative funding period, potentially exceeding the insurance fund’s capacity. As of writing, the insurance fund stands at $32.6m, or about 1.6% of the total USDe supply. It is also worth noting that a significant amount of the reserve fund (about 11.3m at the time of writing) is comprised of Uniswap V3 USDe-USDT LP positions, which could trade below par-value in a drawdown scenario.
    Source: Ethena (April 7th, 2024)
  4. Morpho Oracle Hardcoded to 1:1: Maker’s integration with Morpho Blue, through the DIRECT-SPARK-MORPHO-DAI loan facility supporting DAI-USDe/sUSDe isolated lending pairs, raises concerns. The Morpho oracle being hardcoded to a 1:1 ratio may not accurately reflect market conditions and risks. Moreover, the aggressive Liquidation LTV (LLTV) on some of Morpho Blue’s isolated markets (up to 94.5%, or leverage up to ≈18x) makes them more susceptible to bad debt and faulty liquidations, potentially leading to losses for Maker and impacting DAI’s stability.
  5. Leverage and Liquidity Risks: As Ethena grows, the ratio of available liquidity to protocol size becomes crucial. The main venues for secondary liquidity, such as Curve and Uniswap, are relatively small compared to Ethena’s market cap. The 7-day withdrawal queue on staked ETH collateral could amplify risks during market stress, potentially causing further instability in the secondary market.
    Source: Curve and Uniswap V3 pools, April 7th, 2024
  6. Ethena’s Risk Management and Governance: Limited information regarding Ethena’s risk management practices, governance structure, and decision-making processes hinders stakeholders’ ability to assess the protocol’s capability to navigate challenges and maintain USDe stability.
  7. Legal and Regulatory Concerns:
    a. Regulatory stance on USDe: Ethena Italia S.r.l. holds a VASP registration in Italy, but this does not exempt it from additional regulatory requirements in other European countries where it may operate. The upcoming MiCAR regulation in the EU will introduce a unified scheme for crypto-asset service providers that Ethena needs to strategize for.
    b. Compliance with laws and regulations: Ethena must conduct thorough AML checks on funds and clients as a registered crypto service provider. However, current obligations still need to meet the full scope of consumer protection under MiCAR. Ethena must provide more comprehensive risk disclosures and documentation to align with evolving standards.
    c. Impact of regulations on USDe as collateral: If Ethena faces difficulties obtaining necessary MiCAR licensing, its operations with the USDe token could be deemed unauthorized, severely impacting protocols using USDe as collateral. Restrictions on offering yield on e-money tokens is another key aspect Ethena must navigate. Close monitoring of ESMA consultations and proactive engagement with regulators is advised to mitigate risks.

Despite the concerns raised, Ethena’s integration with Maker DAI does not pose an immediate systemic risk for Aave. Maker’s max exposure of 1B USDe is expected to remain below 20% of DAI’s total backing, and Maker has demonstrated resilience in handling risky collateral, including over 3B of off-chain real-world assets (see our DAI Exposure to Real World Assets report), without experiencing significant adverse consequences.

Based on these considerations, we believe the conservative option presented by Chaos Labs to gradually reduce DAI LTV parameters on Aave is prudent at this stage. That said, the risk environment is dynamic and warrants ongoing monitoring. As a general principle, we believe in taking proactive steps that sufficiently address and respond to changing risk factors in a way that is least disruptive to Aave users.

Moreover, market participants using leverage on staked USDe should exercise extreme caution due to the limited liquidity relative to USDe’s market cap, which could lead to depegging events during large redemptions.