We thank everyone for their deep involvement and discussions. While switching to USDT-pegged USDe pricing may not be the solution preferred by Aave delegates, our stance is that the status quo does not produce an optimal outcome for Aave in potential adverse scenarios. It is essential to recognize that Aave currently bears the majority of USDe/sUSDe insolvency risk; we aim to further expand on this point.
As we continue our collaborative efforts with SPs, delegates, and the Ethena team, we are eager to share our progress on establishing more specific estimations for the bad debt scenarios and potential risk mitigation.
Bad Debt Scenarios
There are two general scenarios to assess potential bad debt from sUSDe-backed loans on Aave:
- Scenario 1: Temporary depeg while USDe remains solvent (collateralization >100%)
- Scenario 2: Insolvency event, with secondary market de-peg and sUSDe/USDe exchange rate decreases
In both scenarios, bad debt can accumulate if the loan’s effective LTV (market-priced) surpasses 100%. If loans cannot be liquidated, scenario 1 would result in temporary bad debt, while scenario 2 would result in permanent bad debt. Below are risk estimations for both scenarios across proposed pricing mechanisms, using current sUSDe market parameters on Aave.
| Price Feed | Loans Liquidatable | Unprofitable liquidations |
|---|---|---|
| USDe/USD market price (current) | Loans liquidatable if USDe depeg is larger than -2.5%. ~263M sUSDe collateral is subject to be liquidated at -2.6%. | Liquidations are unprofitable if sUSDe/USDe secondary market discount exceeds 4% (LB) |
| fixed 1:1 USDe/USD rate | No liquidations | No liquidations |
| 1:1 USDe/USDT rate peg | 42% of borrows are in USDT, rendering part of collateral non-liquidatable. Loans liquidatable if USDT depeg is larger than -11%. ~100M sUSDe collateral is subject to be liquidated at -14.5%. | Liquidations are unprofitable if sUSDe/USDT secondary market discount exceeds 4% (LB) |
A USDT rate peg would effectively improve the buffer until the first liquidatable loans appear, also resulting in more gradual liquidatable amount increases (vs. steep increases observed with the current price feed). These loans can only be liquidated profitably when sUSDe/USDT’s secondary market discount remains below the 4% liquidation bonus threshold.
Source: LlamaRisk, January 6, 2025
Likeliness of liquidations becoming unprofitable
Profitable liquidations under the current USDe secondary market pricing and USDe/USDT rate peg pricing require the sUSDe/USDT or sUSDe/USDe secondary market discount to stay below the liquidation bonus.
Historical market stress events demonstrate sUSDe’s price sensitivity. During stress on August 5, 2024, sUSDe’s secondary market price dropped by 3% while USDe maintained its peg. In a separate instance, a minor USDe de-peg of 20 bps triggered a disproportionate sUSDe response, creating a 1.2% discount. These events suggest that a significant USDe de-peg could cause sUSDe’s price to fall beyond the 4% liquidation bonus threshold, rendering liquidations unprofitable.
Source: LlamaRisk, 8th of January, 2025
For the USDT pricing setup, the discounts would be slightly higher, especially if, at times of sUSDe de-pegs, USDT’s secondary market price has not deviated.
Source: LlamaRisk, 8th of January, 2025
Bad Debt Threshold
The sUSDe sell-side liquidity charts estimate the amount of sUSDe collateral that could be liquidated under current market conditions. However, if USDe de-pegs, sUSDe is likely to experience a more severe de-peg, further depressing its liquidity depth. When loans cannot be liquidated, the risk of bad debt emerges.
Supporting ChaosLabs’ analysis, our price impact simulations show 15-20m sUSDe sell-side liquidity under 4% price impact over the past 3 days. Extrapolating out the recent scenario where sUSDe price impact decreased from 25m to 5m on a ~0.5% USDe depeg (a reduction of 80%), we may assume that a 2.5% USDe depeg results in a further 5x reduction in sUSDe liquidity depth. At times when liquidations become necessary to preserve Aave’s solvency, it may only be possible to execute 1m sUSDe worth of liquidations.
Source: @ChaosLabs
Temporary bad debt would begin accumulating at a USDe de-peg of -10.9%. While data indicates some liquidations may still be executed effectively, a worst-case scenario where USDe de-pegs by 2.5% and sUSDe/USDe secondary market discount exceeds the liquidation buffer would render all sUSDe-backed loans unliquidatable. If USDe continues to de-peg without any liquidations, at -11.5%, approximately 263M sUSDe collateral would be backing bad debt.
Permanent bad debt would occur if USDe collateralization falls below 89.1% (point where effective LTV exceeds 100%). At this point, no liquidations could be executed effectively. However, stress in USDe solvency may potentially be detected earlier, allowing immediate mitigation measures.
Takeaways
Current and prospective sUSDe liquidity conditions indicate that effective liquidation of sUSDe collateral would be unlikely if a liquidation point is reached. Even assuming the sUSDe peg relative to USDe remains within bounds of the liquidation bonus, it is projected that merely 1m of 263m liquidatable sUSDe can be profitably liquidated in the case of a 2.5% USDe depeg. This is a 0.38% success rate, though these calculations are based on limited historical data and could vary significantly under different market conditions.
Given that a recent minor USDe de-peg of 20 bps was accompanied by a 1.2% sUSDe discount, it may be the case that a severe USDe depeg of 2.5% would result in a dramatic sUSDe depeg that far exceeds the liquidation bonus. This may effectively prevent any liquidations from taking place, regardless of the pricing strategy employed by Aave.
Critically, this means Aave bears the majority, if not all, of USDe/sUSDe insolvency risk, regardless of the pricing method used. Therefore, Additional measures are needed to minimize Aave’s chance of accruing bad debt in the case of a potential insolvency event.
Possible Solutions
We have considered multiple mechanisms to address the risks outlined in our analysis. These mechanisms are designed to enhance the risk management of sUSDe collateral on Aave and equip the protocol with effective bad debt exposure mitigation mechanisms.
Automated Guardians
To proactively mitigate the risk of USDe solvency stress and limit the accumulation of bad debt on Aave, we propose implementing a mechanism that leverages a “Killswitch”. This mechanism would monitor Ethena’s first-line solvency stress indicator: the USDe redemption buffer.
An automated guardian could adjust the LTV ratio to zero dynamically when the buffer falls below a critical threshold. ChaosLab’s analysis defines this threshold as a buffer of less than $28 million. For example, if the redemption buffer remains below $28 million for more than 10 blocks, the LTV for sUSDe collateral could be set to zero. This adjustment would prevent existing sUSDe depositors from taking additional loans against their collateral, limiting the creation of further bad debt. With existing borrow levels, up to $110 million in stablecoins could be borrowed against the provided sUSDe collateral. The proposed mechanism would effectively cap this exposure.
Source: ChaosLabs, 3rd of January, 2025
Reducing the LTV to zero would prevent the creation of new sUSDe-collateralized positions - assuming supply caps are not maxed out - protecting Aave from being used as an exit liquidity venue and minimizing the risk of additional bad debt accumulation.
Further Risk Parameter Adjustments
As noted, the sUSDe/USDe secondary market discount mustn’t surpass the liquidation bonus (LB) buffer. As the analysis here emphasizes, this buffer could be insufficient due to low secondary market liquidity. Therefore, the liquidation bonus could be increased further. This would not immediately impact borrowers, but would help improve the likelihood that loans could be liquidated effectively (at a profit for liquidators).
Peg Target Price Feed Adapter
Crediting the solution suggested by @stani, instead of pegging the USDe price to the USDT secondary market price as a protection against unexpected liquidations, an oracle price adapter could be used. Targeting a peg of -5%, when the USDe secondary market price is within the defined bounds, the oracle value would be set to price USDe 1:1 with USD. If the USDe secondary market price depegs by more than -5%, the adapter would switch to the original USDe/USDe secondary market price feed. This pricing solution would achieve the same goals as our previously suggested one without exposing users to external USDT risks. This price adapter solution would need to be implemented by @bgdlabs.
Disclaimer
LlamaRisk serves as a member of Ethena’s risk committee.