Proposal: Dynamic Risk Parameters

Proposal: Dynamic Risk Parameters

Summary

A proposal for continuous market risk management to optimize yield, capital efficiency, and mitigate depositor losses.

Background

Across DeFi protocols, some things never change. Depositors want risk-adjusted yield, borrowers want capital efficiency, traders want lower fees, liquidity providers want to avoid impermanent loss, and the list goes on. Everything else changes from the participant behavior to the market microstructure. These are market risks.

Aave’s Risk Framework shows the importance this community puts towards understanding and mitigating risk. Over the past year, Gauntlet deployed our simulation platform to model Aave V1, V2, and the Safety Module under extreme market conditions. We were happy to report the protocol structure is broadly sound and made risk parameter recommendations to further reduce insolvency risk.

Preventing insolvency is not the only market risk Aave faces. Deflationary spirals and shocks to market prices can’t simply be prevented without reducing the protocol’s utility. Tail-event scenarios are rarely the result of bad actors taking malicious actions against the protocol. The vast majority of Aave’s participants are honest but what’s good for the lender is not always good for the borrower. Depositors lend, borrowers borrow, and liquidators rebalance. This intersection is where Gauntlet comfortably sits, directing traffic per the stated desires of the community.

Gauntlet continues to rerun our simulations since publishing the Market Risk Assessment. What we observe is regular changes in the optimal risk parameters, which raise several questions. Is the market risk framework only needed at asset onboarding? Is the existing framework good enough? Or does it block the next wave of protocol growth? Do changes in volatility and liquidity risk need to be accounted for as TVL grows?

Proposal

In the following sections, we will outline the case and goals for dynamic risk parameters. The initial proposed scope will be small to control for the target metrics Gauntlet aims to improve. Those metrics are:

  • Risk-adjusted yield for Depositors
  • Capital efficiency for Borrowers
  • Mitigate Depositor losses

Gauntlet will improve the metrics above without increasing the net insolvent value percentage or the slashing run percentage. See section 5.3 of our Market Risk Assessment for more details.

Illustrated in the examples below are the benefits from our parametrizations made during the V1 to V2 migration. Additionally, we dive into the adverse effects that recent market conditions have had on parameter recommendations yet to be changed.

Increasing Depositor yield - $230M USD or 1.5% increase in annualized lender income

From parameter suggestions made in November 2020, Aave V2 safely increased borrow risk parameters for multiple assets from the V1 to V2 protocol. For example, increasing Loan-to-Value (LTV) and Liquidation Threshold for collateral assets like ETH, WBTC, USDC, and LINK afforded borrowers better health factors and increased demand.

The largest weekly average TVL (February 17-23) for Aave V1 was $3.0B. In that week, accrued interest was approximately $1.2M—for an annualized yield of 2.08% across all depositors.

For Aave V2, the largest weekly average TVL (May 10-17) has been approximately $12.7B. This week alone generated $8.6M or a 3.52% annualized yield. Conservative estimations that control for liquidity mining incentives still return a 2.5% annualized yield.

Improving Borrower Capital Efficiency - Average WBTC, LINK, ETH collateralization ratios reduced between 34-50%

Data from user behavior from Aave V1 (from February 17th, 2021) to Aave V2 (from April 27th, 2021) reveals significantly more aggressive collateralization ratios. The same adjustments to risk parameters that increase depositor yield allow borrowers to improve the capital efficiency of their positions. We do not assume that risk parameter changes exclusively drove increased borrow behavior. That said, attributing a small portion to improved health factors backed by stress tests via simulation is justifiable.

From V1 to V2, the average user utilizing WBTC as collateral saw a health factor reduction from 4.00 to 2.57 (36%). For LINK from 6.31 to 4.16 (34%) and ETH/WETH by 8.10 to 4.03 (50%).

Maximizing borrow behavior without sacrificing protocol safety is an essential optimization for protocol resiliency and against liquidation cascades.

Mitigating Depositor Losses - $4M USD (1.3%) of total liquidation value between May 17-23, 2021

Detailed at length in our report (see Sections 6.3, namely 6.3.1 on page 22-23) is the risk of high liquidation bonus values. If the lowered liquidation bonus values suggested were implemented, Aave would have mitigated depositor losses while maintaining a low risk of insolvency. For example, our March liquidation bonus recommendations would have mitigated $4M of losses for 590 distinct users from May 17-23.

Asset Current Liquidation Bonus Liquidation Bonus Recs. 2021-03-04 Mitigated Liquidation Value
WBTC 10% 7.5% $2.1M
LINK 10% 7.5% $1.1M
YFI 15% 12.5% $450K
CRV 15% 12.5% $90K
XSUSHI 15% 12.5% $100k

Expectations

  • Risk Parameter Updates

    • Exclusively for Aave V2 assets
    • Supported Risk Parameters: Loan-To-Value, Liquidation Threshold, and Liquidation Bonus
    • Market conditions will determine the frequency of updates. For that reason, no SLA will be preset.
    • A Risk DAO may make the most sense to provide oversight and management of all risks associated with Aave. Gauntlet would be complementary to the Risk DAO to coordinate parameter changes. Gauntlet will proceed with the manual ARC to AIP process unless circumstances change.
  • Communications

    • Risk parameter changes will follow the standards suggested for the Aave Snapshot Space.
    • Quarterly, Gauntlet will post a Snapshot vote to determine the preferred risk tolerance of the community. The outcome of this vote will determine the risk and capital efficiency tradeoffs Gauntlet will target.
    • Monthly forum posts and participation on community calls with explanations of risk parameter changes and any anomalies observed.
    • Risk Dashboard (refer to the next section)
    • Quarterly Risk Reviews will provide a detailed retrospective on market risk.
  • Out of Scope

    • Aave V1, AMM, and Polygon Markets
    • In line with keeping the scope small, Gauntlet will not look to manage the following at the outset:
      • Enabling or disabling a currency for borrowing
      • Setting interest rate strategies
      • Configuring the caps (borrow caps, supply caps, exposure ceiling)
      • Configuring Reserve Factors
    • An implementation using the soon to be merged riskAdmin role.
      • Should this experiment be a success, we would seek whitelisting to make updates with more precision.

Risk Dashboard

As part of this engagement, Gauntlet will build a Risk Dashboard and API for the community to provide key insights into risk and capital efficiency.

Please note, all numbers are for illustrative purposes only and do not reflect the current or possible future state of Aave V2.

The dashboard focuses on both the system-level risk in Aave V2 and the market risk on an individual collateral level. Our goal is to help convey our methodology to the community and provide visibility into why we are making specific parameter recommendations.

The dashboard will monitor all collateral assets in Aave V2. The two key metrics are Value at Risk (VaR) and Borrow Usage.

Value at Risk conveys capital at risk due to insolvencies and liquidations when markets are under duress (i.e., Black Thursday). The current VaR in the system breaks down by collateral type. We currently compute VaR (based on a measure of protocol insolvency) at the 95th percentile of our simulation runs assuming peak volatility in the past year. We do this using Aave’s current parameters as well as after modifying the parameters to the Gauntlet Recommendations.

Borrow Usage provides information about how aggressively depositors of collateral borrow against their supply. Borrow usage is a measure of capital efficiency and builds on past work for Aave. Defined on a per Asset level as:

where U is the utilization ratio of each user:

We aggregate this to a system level by taking a weighted sum of all the assets used as collateral.

To show Gauntlet’s impact, we measure these using the current system parameters and expected results (based on our simulations) if Aave were to implement the parameter recommendations suggested.

Cost

Gauntlet charges a service fee that seeks to be commensurate with the value we add to protocols. In Aave’s case, despite various exogenous factors, Gauntlet can be more confident in the expected impact of our proposal given our prior recommendations to the Aave Genesis team. Gauntlet also wants to provide a strong signal of our alignment with the protocol. For that reason, we propose a service fee denominated in stkAAVE with an additional linear vesting period of 6 months for half (½) of each quarterly payment. Multiple comments suggested a similar vesting structure in the liquidity incentives proposal thread. In addition, Gauntlet will deploy the OpenZeppelin Token Vesting contract to provide the community a revocable option should our impact or engagement be deemed unsatisfactory. At the start of every quarter for one year Gauntlet will request service fee payment via AIP.

The formula to calculate Gauntlet’s service fee has four components:

  1. An asset multiplier to track risk management complexity
  2. A proxy for capital efficiency
  3. A base fee
  4. Aave price

The asset multiplier calculation is log(Number of Assets, 10)*. New assets on the protocol add complexity to risk management. While the market risk optimization problem does not grow linearly, consideration should be taken when onboarding assets. For example, xSUSHI has no real market data, and modeling requires taking staking yield into consideration.

The most straightforward proxy for capital efficiency is the total borrowed** for risk-managed assets—only V2 assets initially. Capital efficiency is realized by borrowing demand.

Gauntlet’s risk management base fee is 10 basis points annually, derived from a conservative estimation of the impact from dynamic risk parameters. See examples above.

The USD price of AAVE. Whether the price should be fixed or calculated quarterly, different communities have different opinions on how this aligns incentives. We will defer to the preference of the community but will default to calculating quarterly.

Gauntlet quarterly service fee = log(Number of Assets,10) * Total $ Borrow * 2.5 basis points / AAVE price (tables below calculated at $312)

Gauntlet quarterly service fee denominated in AAVE

Growth and drawdown examples


*Log value is the minimum of the tier range except in the “<= 10” column, where it is 10. For example Column “21-25” returns log(21,10)

** Rounded down to the nearest $1B
*** When Total Borrow < $3b, there is no basis point fee. The formula is log(Number of Assets,10) * $1,200,000 / 4 )

About Gauntlet

Gauntlet is a simulation platform for market risk management and protocol optimization. Our prior work most relevant to Aave, includes assessments for Compound, MakerDAO, Liquity, and of course Aave. Gauntlet’s continuous parameter optimization work includes Balancer, SushiSwap, Vesper, and Acala.

Thanks to @tarun , @wfu, @shaan, @jmo and many others for assistance on this ARC.

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Disclosure: Standard Crypto is an investor in both Aave and Gauntlet.

I wanted to voice Standard Crypto’s support of this proposal.

We think, broadly, that there’s an opportunity to level up how the Aave community assesses risk and tunes protocol parameters in accordance. And that further collaboration with Gauntlet, the market leader in DeFi risk, is a step in the right direction.

We think of this as an experiment and like that it is scoped with ample opportunity to disengage on a quarterly basis if the Aave community isn’t getting the value we’re looking for.

Excited to discuss this further with the community!

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Very excited to see this proposal come through - Pantera is supportive. Gauntlet has been extremely helpful in bringing a new level of rigor to protocol risk and market risk assessment. I see their work as highly complementary to the current efforts going towards establishing Aave’s RiskDAO and a consistent risk framework.

As asset complexity increases - e.g., assets with unique behavior like AMPL, productive assets like xSUSHI, assets building off other assets, etc. - it’s increasingly important to have community partners that can adapt / digest that complexity and translate it into trade-offs to support community decisions.

Beyond our high-level, enthusiastic support for this proposal, I wanted to also point out the alignment in the cost structure. Had some early feedback to the Gauntlet team on this and I think this version is strongly aligned and includes the right levers to drive Aave’s growth responsibly.

Hopefully the community doesn’t skim over this because it’s great. TradFi is used to seeing advisors / service providers that take a broad % of AUM or volume without much thought re: asset mix or actual effort required. The formula Gauntlet proposes here takes into account:

  1. number of assets (how hard the work getting)
  2. total borrow demand (how the work supports growth / usage)
  3. base fee (keeping the lights on / increase alignment)

Those levers make a lot of sense and work really well to align the success of this initiative with the cost. With that said, certainly agree with @Alok_StandardCrypto on the periodic review, especially as the RiskDAO starts taking a clearer shape / role.

Franklin @ Pantera Capital

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This is Ratan, President of Blockchain @ Berkeley.

We believe that Gauntlet has proven itself to be one of the leaders within the DeFi space, and we see incredible value to the Aave community in implementing dynamic/continuous market risk management to enable the protocol to be more effective for Aave users. With the exponential increase in the usage of Aave since v2 began, we believe that having Gauntlet complement the proposed Risk DAO for parameter updates enables both a more balanced and incentive-aligned system for parameter updates. Additionally, we believe that this partnership provides a clear model for collaboration on future initiatives between the Aave ecosystem and DeFi platforms.

Furthermore, we believe that the OpenZeppelin Token Vesting contracts provide a clear methodology by which the Aave community can decide whether or not to continue the program based off of their satisfaction with Gauntlet’s execution.

We really appreciate Gauntlet’s transparency in their reasoning and calculations behind the service fees taken for running the service - and this should be the standard moving forward - as it provides the community with a clear understanding of the sizing of the fee. However, we believe that this proposal would benefit from additional transparency on the Gauntlet side for how these funds will be used (i.e. estimations on Gauntlet team/infrastructure costs, etc.) - as more transparency on DeFi initiatives such as these is always better than less.

As a side note - we also are strong proponents of open developer resources to the DeFi community such as the Risk Dashboard & API and are excited to see this included!

Overall, we’re in strong support of this proposal and are excited to help contribute to shape it alongside the Aave community. Thanks @inkyamze and the rest of the Gauntlet team in putting this together!

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Welcome to the community @ratankaliani and thanks for the kind words! As you mentioned and we hope the proposal indicates, we have a strong inclination towards transparency and building tools for the community.

We are a team of 21 and are actively hiring to better fulfill the needs of engagements like the one proposed above. Of course, Gauntlet would not direct all of our engineering/data science/product/program management resources towards a single engagement. That said, our model and simulation work on other protocols, not just liquidity protocols, result in better assumptions and risk management for individual protocols like Aave.

Inputs have costs. Some of these costs have been partially accounted for from our prior engagement writing the Market Risk Assessment. For example, ETLs, Aave V1/V2 contracts integrated into our simulation SDK, baseline QA processes, and some Kubeflow automation.

Outputs provide value. As mentioned, Gauntlet seeks to charge commensurate to the value provided. Our goal is to drive down costs while increasing the value added to Aave. The better we do this the better we can service the protocol. Fortunately, we are well capitalized and can focus on delivering value over driving down costs. The Risk Dashboard and API are a good example of value bets we would like to take that have a large costs (development, automation, maintenance).

As a reviewer on the Aave Grants DAO, I heavily weight towards the value a grant application will provide to the community over the cost. If we fail to do so it will be even tougher to attract top talent to tinker, build, and iterate on the protocol. There are various RFPs and significant resources that are already difficult to fulfill and deploy.

We hope our value provided resonates with the community.

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Hi there,

Conceptually, I like very much the idea of having dynamic risk parameters, it makes sense to automatise and sytematise anything that can be.
What would be the implication for borrowers though - would they be expected to constantly monitor and adjust their leverage to make sure they don’t get liquidated in case of a change in Liquidation Threshold?

As both a borrower and a AAVE holder, I don’t think that would be attractive at all. The way around that would consist in applying the latest dynamically adjusted parameters to new loans only (e.g. At time T when Liquidation Threshold was 80% I made a loan using ETH as collateral; At time T+1 risk parameters get updated and Liquidation Threshold for ETH drop to 75%, my LTV is 79% but I am still good because this is below the Liquidation Threshold at the time I made the loan).
Is that how you were thinking of implementing it and how it has been accounted for in your analysis?

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Fantastic proposal at an extortionate price. How to justify spending $8m/year on an external centralised software that is not fully understood, validated? Based on the current ARC, no one would even be working full-time for the Aave Protocol right?

The scope is extremely limited to just some of the risk parameters - what about other risk parameters and other risks? The budget should start small and expand with Gauntlet’s risk management mandate across the Protocol with a focus on reducing risk rather than capital efficiency.

Gauntlet has already been working for Aave producing the great Aave Market Risk Assessment and various parameters suggestions. This means the Aave contracts are already integrated right? if the pricing for work mostly already done is $2m per quarter what will it be for new work? Reading through the forum seems only minor changes were suggested + a validation of the current model and important deep review - is this worth $2m/quarter?

Since the focus is quite specific on just a few of the risk parameters, the price could start smaller, increasing as Gauntlet provides more recommendations on the interest rate model or other key risk calibrations for the protocol.

How much are the other projects using Gauntlet’s continuous parameter optimisation paying?

With this kind of budget Aave could hire the best talent, full time for the Aave Risk DAO. They would build proprietary models by Aave for Aave - just like banks do


Thanks for the disclosures ;)

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@3.1415r The user experience (UX) of borrowers is a large consideration for us and something we highlighted as an existing concern (see Next Steps) for Aave without dynamic risk parameters. Gauntlet has also performed various ad hoc measures to avoid liquidations for other protocols.
We should also clarify that volatility and parameter adjustments are largely misunderstood in DeFi and will not be as frequent as users suspect. As mentioned, we look forward to coordinating with a Risk DAO and broader community to get the cadence and messaging just right.

Unfortunately, your example can not be implemented in the protocol as it stands today. Previously there had been discussion of supply/borrow caps that could be updated dependent on specific positions but maybe someone more familiar with upcoming protocol upgrades can chime in with the status on that.

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@Aavenger Thank you for the hard-hitting questions. I will attempt to answer all of your specific questions. Questions I interpret as prompts for the community to consider, much appreciated because this is an ARC, I will skip.

Correct and we would suggest this is not preferred. Monitoring and managing risk for numerous protocols allows our data scientists and engineers to improve our models ahead of realization events occurring on Aave.

Those highlighted as Out of Scope were called out for three main reasons. First, they broadly do not impact our target metrics and would make our impact less measurable. Second, they are permissions on the riskAdmin role that we wanted to be clear would not be exercised. Third, Reserve Factor is the only risk parameter excluded because it is used to sustain the DAO rather than cover solvency risk.

Aave v1 and v2 contracts are integrated into our platform along with dozens of other protocols—including some in which no commercial relationship exists.

Other liquidity and lending protocols have and will be presented the same pricing. The only protocol I can publicly mention currently is Benqi which will be officially announced tomorrow.

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Interesting proposal, dynamic adjustments seem interesting. You mention you have 21 full time staff, so you would like to make 8m/21= 380k each working part time, on this as its one of 5? Protocols you’re working with? Sheeesh
I’ll be voting no, but open to renegotiating for a lower fee.

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Agree with the pricing being astronomical, paid $16 just to vote no, not enough AAVE to affect things, but if this goes through, will have a lot less as spending 8m a year on this is not fiscally responsible especially in the face of very clear regulatory battles that are coming.

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@inkyamze
Since your fees are quite high and you cannot clearly show the impact on protocol revenues - which is the only arguement for voting yes, it seems only Gauntlet and the users will benefit with heavy quarterly costs for Aave and a very unclear impact on revenues. This is a clear NO.

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@Retropunk @Anono @A5burger Thank you for explaining your rationale here. Regardless of the vote’s outcome we appreciate getting as much feedback from the community as possible.

We have hired 4 more people and will continue to do so since first posting the ARC. Building and maintaining our platform requires significant resources.

We suspect anyone in this forum/community has similar concerns. Gauntlet sure does. We would hope Aave user protection (“consumer protection”) through active risk management may be seen favorably by regulators.

We would like to highlight that liquidity mining or adding additional assets have similar difficulties. Does liquidity mining drive only short-term growth? Does adding additional assets add tail risk to the protocol? Yes, they drive protocol revenue but how much is tough to pinpoint. All protocol changes will face this difficulty and that is why we called out metrics where we can drive the most impact.

One thing from most previous AIPs is clear, the Aave community has a long-term vision and is willing to experiment in the short term. Governance can and should evaluate Gauntlet’s impact quarterly and decide whether to renew our engagement.

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Sorry, in proposals adding additional asset like PAX or AMPL I could not find any fee calculations like yours.
You say yourself it is difficult to determine the benefit, but you are very precise in calculating the fees. And how should the Aave stakeholders should evaluate quarterly the benefits of Gauntlet?

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Here my opinion as a community member about the proposal.
First, I think the Gauntlet team is most probably the best in the industry in what rewards risk analysis on decentralized protocols, knowing first-hand how robust their technology and methodology are. In addition, they have a good knowledge of the protocol and its assets, and how evolved over time since V1, which makes them a perfect candidate for this kind of task. So I support having some type of collaboration between Gauntlet and the Aave Protocol.
That being said, I believe that the future of risk analysis concerning the Aave Protocol, should be completely led by the being-built Aave Risk DAO, with members of it fully committed to Aave. In addition to that, it is obvious that with the magnitude of a protocol like Aave, it is necessary to have external advisory firms working together with the Aave Risk DAO, but the role (as it is actually defined on this initial proposal by @inkyamze ) is as such, advisors.
Taking that into account, I consider the cost vs service of this proposal not adequate. At the current price of AAVE, we are talking about a total of $2.2m for a quarter, for an advisory service on a not fully dedicated team.
I would like to see multiple teams with heterogeneous methodologies advising on risk for the protocol, as that is the most healthy scenario in my opinion, and if all the cost would be similar to the one of this proposal, I don’t see it sustainable with the same terms.

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Dear Franklin
Since you support this proposal and you seem to be invested in Aave could you please show the exposure of Pantera to Gauntlet. Thank you so much.

I appreciate the work put into this proposal and I like the dashboard.

I say we include in this proposal hard financial targets the Gauntlet must hit for AAVE in order to secure the majority of the compensation they are seeking here. I would also support a longer vesting period (4 years not 6 months) to ensure the changes are to the protocol are not short term in nature.

It looks like even if your initiatives fail to improve the economics for Aave holders you get paid in every scenario?

“Gauntlet’s risk management base fee is 10 basis points annually, derived from a conservative estimation of the impact from dynamic risk parameters.”

So you are basically saying more utilization = efficiency. I think this needs to be more fleshed out b/c I can’t quite figure out where Aave users are getting the value we are paying Gauntlet. If that could be more obvious I could be supportive of this proposal.

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@Retropunk - happy to do that. Neither I nor Pantera have any direct / financial / etc. exposure to Gauntlet.

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Gauntlet should work directly with Zerion or Instadapp, not charge service fee from AAVE community.
There should be different layers on defi, AAVE should minimumize potential risk and being the No.1 on borrow/lending, The key is being stable/consistent and low risk.

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As an Aave user and an experienced tradfi risk manager, here is my view on the above proposal:

  • It make sense for Aave to strengthen its risk monitoring and reporting to bring more information and efficiency to its protocol user and also to regulators - when regulators will look into Aave they will want a strong risk management function and a strong accountability from Aave’s team. Asking external provider to contribute make sense.
  • Beyond choosing Gauntlet, the question is what is the expected role and the associated price for it. There is a role of software provider (tool, data) - good idea to buy rather than built a risk system that cost so much to banks and a role as risk advisor on risk methodologies (parameters calibration, indicators…). Looking at those 2 roles (is Gauntlet doing both?) I don’t see how you can justify the cost. As it is said, with 8M/year you can have a large team dedicated to your protocol; here it is a payment to use a software that seems to also be shared with other protocols and already linked with aave systems. and for the advisory part, not sure what it means.
    The only backstop is that it can be revoked quarterly but will we be able to do it when all the reports and data are used by the community/investors/regulators and Aave risk team relies on Gauntlet to recalibrate risk parameters. The fee calculation could take into account revenues; with TVL only,we won’t see revenues going down as margin reduces with more competitive/mature markets; also with such fee structure, gauntlet is a not just a software provider but a proper stakeholder of Aave (neither good or bad, just factual).
  • Ideally, this Gauntlet proposal should be put in competition/compared to a benchmark and reviewed/discussed between Aave risk team and the upcoming Aave risk DAO
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