Hello @Gauntlet and thanks for this proposal,
At the Aave-Chan Initiative, we firmly believe that the secondary market should not be the crucial focus for LSTs. This is primarily because every LST onboarded on Aave is an asset with a functioning primary market (with ETH being the most recent since the Shapella upgrade). Consequently, the secondary peg will always have inherent market forces working towards its restoration in the event of a depeg.
As a protocol, it’s also essential to distinguish between excess debt and bad debt, with the former being temporary in nature or not necessarily turning into bad debt.
For instance, with large volumes of stETH can be minted in the primary market within seconds, the secondary market for acquiring stETH has become less relevant post-Shapella., it’s also possible to redeem large volumes of ETH from stETH, as evidenced by the 440k stETH redemption event from Celsius.
In the case of Polygon, one stMatic or maticX equates to a MATIC in three days via the primary market.
These observations lead us to a firm conviction that, barring smart contract risks, the worst-case scenarios for LSTs are likely scenarios where the Aave protocol has excess debt, which is likely to be resolved with little to no bad debt after a few days.
The proposed killswitch adopts a more aggressive approach by using the Liquidity Threshold (LT) as a tool and triggering user liquidations. We believe this may not be the optimal approach. Forcing users into a position of potential liquidation, when it’s highly likely their position Health Factor (HF) would have been safe a few days later without any action, does not align with our commitment to safeguarding our user base. Moreover, we are concerned that the killswitch could trigger a self-fulfilling prophecy effect on the secondary market depeg and potentially incite unnecessary market panic. Lastly, it could potentially create opportunities for malicious actors with substantial resources to artificially maintain “artificial” depegs to benefit from liquidations, acquire cheap LSTs, and gain liquidation bonuses.
Despite these primary concerns and observations, we do acknowledge that a “killswitch” to freeze markets and slow down processes might have benefits. Such mechanisms exist in traditional finance, and while DeFi is harder to “control”, it might limit damage in extreme market scenarios.
If a lighter Killswitch is not an option, we’re currently leaning toward Option 2 without the first trigger at 1.25% price derivation which seems too sensitive for us.