First, really appreciate Gauntlet’s contribution in initiating the discussion, as we agree that being as precise as possible on pricing LSTs is one of the main challenges these next months and a quite complex topic.
From our side, we agree that some kind of “killswitch” mechanism could be important to implement on assets like LSTs, but we have doubts about the proposed options.
Adjustment of borrowing asset’s rates when secondary market liquidity “dries”
The objective of the first part of the proposed kill-switch is to reduce the size of the LST collateral in the protocol, whenever a de-peg event is noticed on the “secondary market”, due to low liquidity. Our feedback is:
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By raising the slope 1 in order to break the “leverage loop”, users get quite hurt, and in a way that could make them migrate away and not migrate back.
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If liquidity is low, this can (and is as explained in the second part of the proposal) mean that liquidations are not really attractive on Aave. So increasing the slope just accelerates positions entering liquidation that would not in other cases.
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If we trust “primary market” pricing (exchange rate), there should not really be much reason to believe that with the standard slope 1, positions entering in liquidation due to interest accumulation will not be liquidated, as with current configurations would take months to accrue even 2-3%.
If the peg doesn’t recover for months, the assumption of the primary rate is broken.
So on this part of the proposal, yes, we see the rationale of reducing the exposure of the protocol, but by accelerating debt accrual of positions that most likely won’t be profitable to liquidate already, the mechanic hurts the user and increases the likeliness of bad debt accrual.
LTV0 and LT lowering when primary/secondary price de-peg is detected
Regarding the second part, for us, it feels similar to the first, a bit counter-productive, for the following reasons:
- If there is a meaningful dislocation of price on secondary versus exchange rate, that directly implies that liquidating in Aave is most probably not worth it compared with acquiring the LST on DEXes. By lowering LT, in practice, the protocol is swapping the pricing method to some kind of hybrid between primary and secondary, but not really repricing the incentive of the liquidator, because LB stays the same.
- Consequence of the previous, if we assume that precisely in those situations of de-peg no extra liquidations will happen, then adding more liquidatable positions doesn’t sound like a good idea. Even more, if we assume the de-peg is temporary (which we should, following the reasoning of using the exchange rate), there could be even problems with “safe” positions once it recovers, if the LT doesn’t change up dynamically too.
So in summary, by lowering LT, liquidations don’t seem to get more attractive for the liquidators - it just increases the number of accounts that can be liquidated. If a user doesn’t liquidate before he likely won’t get liquidated after. Therefore the lowering of LT will likely only show an effect when the peg recovers and healthy positions get liquidated due to temporarily lowered LT.
If we go to the core of the rationale of a “kill-switch”, these protections based on slight adjustments are not really aligned with the main assumption of the system: exchange rate pricing is fair pricing. In practice means, if we see a meaningful risk of permanently de-peg on an LST, the right LT is not 93% or 97%, it is 0; not listing it as collateral.
For us, a kill switch should be more on the side of the proposed LTV0, freezing, and pause actions, combined with some type of Proof-of-Reserve which we are studying to expand from the current use cases on Aave (bridged assets).
We are happy to keep the discussion going, as by itself will provide enormous value to the community and DeFi in general.