Understanding the Risks of Aave
Let’s look at the risks of the Aave Protocol
At Aave, we are constantly asking ourselves what we can do to make the protocol safer. The market’s explosive growth has increased the stakes and so it is important to remember there are many risks associated with DeFi.
Aave’s Risk Framework breaks down some of the key risks of the protocol and the mitigation techniques in place. Today, we have published a new section focused on liquidity risk.
The liquidity of the protocol is the availability of the capital to face business operations: borrow amounts for loans and redeeming aTokens. It is a key metric, as lack of liquidity will block business operations.
To better understand how liquidity risks materialize in the Aave Protocol, lets analyse liquidity risk through the utilization ratio and the valuation of aTokens. Then we will look at the risk management strategies in place: the interest rate model and the alternative sources of aToken liquidity.
Risk Analysis
Historical Utilization
Each currency reserve is characterized by its utilization rate U which represents the share of borrowed liquidity:
As U gets closer to 100%, the capital becomes scarcer until no liquidity is left at U=100%. This situation can be problematic if depositors wish to withdraw their liquidity, but no funds are available.
Stablecoins are the preferred currency for borrowing. Their reserves are among the most utilized. The chart below shows the historical utilization of Aave’s stablecoin reserves.
Stablecoin utilization is high, hovering above 80% for many assets. Most stablecoin reserves have just about reached full utilization, but sUSD and BUSD have remained fully utilized for some time. These two reserves are the smallest ones, leading to more volatility. Still, full utilization remains very rare, occurring just around 1% of the time.
Occurrences of utilization above 95% are rare throughout all reserves. The most utilized markets are USDT and sUSD, with a utilization above 95%, 6.5% of the time.
The utilization of volatile assets above looks completely different from the stablecoins. Most assets only experience low utilization, they are mostly used as collateral for borrows.
SNX stands out as the token with the highest utilization and lots of volatility. The reserve is fully utilized 8.9% of the time. This is due to the staking mechanism of Synthetix which relies on holders locking tokens to mint synths. Those with large stakes are able to profit even when borrowing SNX with interest. This also impacts sUSD which are minted in exchange for the locked SNX.
Utilization has soared since the 15th of June driven by the large-scale deployment of liquidity mining impacting some of the assets of the protocol. When market conditions change, the Aave team is able to react quickly to adapt to the emerging risks by adapting its risk mitigation strategies (risk parameters and interest rate parameters).
Overall, the utilization of the protocol has remained at appropriate level throughout a changing ecosystem. Each asset has a different liquidity risk profile which needs to be monitored. Assets such as SNX, DAI or BAL that generate income on other platform are more at risk of lack of liquidity. The risk parameters need to be calibrated in line with the incentives of the entire DeFi ecosystem.
aToken Valuation
aTokens are received in exchange of token deposits, they accrue interests from borrowing on Aave. They are redeemable at any time 1-to-1 on the protocol as long as there is liquidity available. Let’s look at different ways we could value aTokens.
The most obvious value of aTokens is their market price. The aDAI Uniswap pool is the biggest source of aToken liquidity outside of Aave. Let’s look at the historical price of aDAI in DAI to assess the peg of aDAI.
The market price of aDAI in DAI is volatile, since inception, the median price is 1 aDAI = 1.05 DAI with the value of aDAI in DAI increasing over time. It is possible to redeem aDAI for more DAI in the markets than on Aave. In case of lack of liquidity on the protocol, users can exchange their aDAI with profit on Uniswap.
This superior valuation is confirmed by the economic valuation theory. The intrinsic value of an asset generating passive income comes from future cashflows, actualized based on market conditions to assess the present value.
- On Aave: APY(aDAI) = 3.50% 30-day average
- 10Y UK Bonds Yields: RiskFreeRate = 0.30%
If aDAI is held for 3 years then redeemed at discounted 1$, the present value of aDAI is 1.10$ (this is based in the theoretical 1 DAI = 1$).
In fact, aDAI is a perpetuity, an asset that generates an indefinite cashflow, leading to a valuation of 11.67$.
Economic theory values aDAI at 1.10$ on a 3-year basis and 11.67$ in case of perpetual payment. This is due to the high yield of Aave compared to the current risk-free interest rates which is particularly low. With a higher risk-free rate of 1.5% the present value is still at 2.33$.
The aToken Valuation analysis shows that both economic theory and the markets place aDAI’s value above DAI’s. This means that users have strong incentives to hold aToken rather than the underlying Token.
There is no liquidity discount on the price of aTokens. If there were some liquidity issues, aToken holders would be desperate to liquidate their aTokens even at a loss.
Risk Mitigation Strategies in Place
Now that we better understand the nature and the occurrence liquidity risk in the Aave Protocol, let’s look at the different tools in place to manage it.
Borrow Interest Rate Model
Aave’s interest rate strategy is calibrated to manage liquidity risk and optimize utilization. The borrow interest rate comes from the Utilization Rate U.
U is an indicator of the availability of capital in the pool. The interest rate model is used to manage liquidity risk through user incentivizes to support liquidity:
- When capital is available: low interest rates to encourage loans.
- When capital is scarce: high interest rates to encourage repayments of loans and additional deposits.
The borrow interest rate Rt follows the model:
Both the variable and stable interest models, are derived from the formula above from the Whitepaper with different parameters for each asset.
- When U<Uoptimal the borrow interest rates increase slowly with utilization
- When U≥Uoptimal the borrow interest rates increase sharply with utilization to above 50% APY if the liquidity is fully utilized.
Variable loans see their rate constantly evolving with utilization. This means they are not ideal for financial planning.
Hence Aave offers stable loans, which maintain their interest rate at issuance until the specific rebalancing conditions are met. For rebalancing the stable rate down, the loan’s stable rate S needs to be greater than the current stable rate St plus a delta equal to 20%: S ≥St + 20%
For rebalancing the stable rate up, these two conditions need to be met:
- Utilization Rate: Ut > 95%
- Overall Borrow Rate, the weighted average of all the borrow rates: RO<25%
When market conditions change, the interest rate parameters can be adapted. These changes must adapt to utilization on Aave’s market as well as to incentives across DeFi.
The interest rate curve of SNX is much higher than that of other assets due to the staking incentives of the Synthetix platform. This makes SNX the most utilized pool generating the highest yields.
With the rise of liquidity mining, Aave also adapted its cost of borrowing by lowering Uoptimal of the assets affected. This increased the borrow costs that are now partially offset by the liquidity reward.
Interest Rate Model Parameters
You can check the live model parameters and assess the borrow interest rate parameters based on the current market conditions on this spreadsheet. Here are the parameters as of 9th of July 2020.
Interest Rate Model Curves
Below the interest rate borrow curves for each of Aave’s primary market asset.
USDC | DAI | USDT
TUSD | sUSD | BUSD
SNX
KNC | MANA | ETH | WBTC
LEND
LINK | ZRX | REP | MKR
BAT
aToken Liquidity
An additional tool to mitigate aTokens’ liquidity risk is to provide alternative sources of liquidity enabling users to redeem aTokens even when there is no liquidity available in the protocol.
Aave has set up liquidity pools on Uniswap and Balancer to add sources of liquidity.
Moving Forward
Some of the risks that affect liquidity providers can be safeguarded through economic token design. The Aave team has been working on some ingenious risk management mechanisms to protect the capital held in the protocol. These are coming soon in the Aavenomics.
