We appreciate the initiated discussion and recommendations proposed to address the risks associated with price deviation between the secondary markets and LSD contracts. After careful consideration, Chaos Labs would like to offer our analysis and recommendations:
-
Freezing Markets: We stand in agreement on the implementation of a killswitch function that reduces the LTV to zero and freezes new supply and borrowing in cases of a price deviation. Such a killswitch would act as a temporary risk mitigation measure to limit the protocol exposure at an early stage of an extreme market scenario without compromising user funds in the more likely scenario of a temporary depeg, or “excess debt” as described by @MarcZeller.
-
Enabling Proof of Reserve Trigger: Rather than adopting the suggested LT reduction above, we propose the initiation of a proof of reserve trigger that would compel an LT decrease. This alternative methodology leverages reserve depletion as a more accurate and dependable gauge of the LST’s price. In instances where reserves are depleted, we advise a corresponding reduction in the LT, mirroring the losses in the reserve and more accurately reflecting the real price of the LST.
-
Lowering of Liquidity Thresholds (LTs): We do not support reducing LT as an automated mechanism due to a price divergence between secondary and primary market prices.
Marc Zeller: 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.
To add to the above, we foresee the liquidation process to be riddled with uncertainty due to the unpredictable profitability and market conditions and believe this could lead to unnecessary liquidations and potential loss of user funds if and when the price of the LST recovers, as observed in the case of the USDC depeg.
In the graph above, we observe the top E-Mode accounts causing the bad debt on Aave V3 Avalanche during the USDC depeg between 03.10.2023-03.13-2023.
The red horizontal line marks the point at which USDC started regaining its peg, followed shortly by the first instances of liquidations (represented by the maroon plot, showing the accumulated amount liquidated). Although accounts were already eligible for liquidations several hours prior, the grand majority of liquidations occurred when the price was recovering, leading to the accumulation of bad debt for the protocol.
Reducing the LTs for LSDs in a similar event of a depeg, could create a similar phenomenon at a much larger scale. Moreover, this could create a cascading effect, pushing markets prices even lower.
- Near-term Parameter Updates:
-
E-mode LT and LTV Adjustments: We would advise against increasing the LT and LTV for the current E-modes until the proof of reserve oracle, or other trigger mechanism is fully implemented and tested. It’s essential to ensure that all risk mitigation measures are fully functional before considering any increase in LT and LTV that could potentially expose the protocol to additional risk.
-
Supply Caps: We believe the increase in supply caps for LSD should be evaluated individually on a case-by-case basis, taking into account the unique market conditions and risk tolerance of the community for each asset. Recognizing the strategic importance and the pivotal role of LSTs in Aave’s revenue generation, we do not wish to restrict potential future increments to the implementation of the aforementioned mechanisms. Instead, we commit to appraising any proposed enhancements to the cap as they are presented.