First Impressions: Aave’s Proposed GHO
The Aave Companies got crypto Twitter buzzing yesterday after announcing plans to propose a new stablecoin — GHO — that could be minted by the Aave protocol and others. Right now, information is still a bit sparse and we’re waiting on some technical and financial details, but here’s what we know now, as well as some challenges that its structure seems to present for Aave.
The Structure As Described
As described, GHO’s initial use would be as a stablecoin that could be borrowed against crypto collateral supplied to Aave. Presumably this would be against an overcollateralized position, as Aave traditionally requires.
The announcement also states that 100% of the interest payments on GHO borrowings would be captured by Aave’s DAO. Those rates would be set at “a stable rate” and adjusted manually through Aave’s DAO. It’s unclear if this is intended to be a fixed rate, or if it’s simply not supposed to adjust in real time based on market utilization.
A unique aspect of the interest rate policy to borrow GHO is that stkAAVE holders could receive a discount to the interest rate. Notably, this is up to 100% discount, which implies that interest-free loans against stkAAVE would be available for whales. Aave Companies even provide a simple Google sheet for illustrative purposes.
Another unusual feature of GHO is the ability for Aave’s DAO to franchise out the rights to mint GHO to “facilitators.
While Aave Companies states clearly any decisions will be up to Aave’s DAO, the suggestions in the graph represent some far-ranging possibilities.
The Potential
Given the Aave protocol’s presence across multiple chains, this represents a chance to simultaneously deploy a new stablecoin across most major chains. By playing the odds, it’s possible GHO manages to consolidate a base of adoption on one or more venues, and is able to then challenge dominant stablecoins repeatedly on other chains from there.
This also provides the ability for Aave to utilize fractional reserves, and become more capital efficient. This is notably one of the main advantages of Interest Protocol, which has pioneered this model on Ethereum. It’s not clear if Aave Companies understand this or will exploit its potential.
The Challenges
We are still awaiting more technical and financial details, but as presented, the announcement suggests some significant challenges will need to be addressed by Aave’s DAO for GHO to operate successfully.
The most striking is that there is no mention whatsoever of how GHO would maintain a fixed exchange rate with other stablecoins in real time. The primary monetary tool that appears in the announcement is the ability for Aave’s governance to alter interest rates.
At the outset, there appears no particular reason GHO should trade at a one-dollar valuation. The introduction of redeemability for USDC, USDT, DAI, FRAX, USDi, sUSD, FEI, or other stables would at least provide a way to stabilize the market price of GHO in real time. Reliance upon borrowers to arbitrage the price up and down through borrow/repay has proven to be a failure at MakerDAO, whose DAI consistently remained off peg until the introduction of redeemability for USDC. Aave’s governance should consider utilizing its protocol reserves if it desires GHO to enjoy a stable price in real time (a must for a stablecoin to scale).
The move away from algorithmically set borrowing rates seems a major step backward. True, this is the method of choice at such venerable institutions as the Federal Reserve and MakerDAO. But the former is a central bank, and the latter has been blessed with the intelligent policy of trying to follow market rates rather than set them. The temptation to set rates at a level to encourage growth of GHO will be high, and it’s unclear if Aave governance has the financial sophistication to utilize such a primitive tool as manual rate setting in a manner that’s safe.
It should be noted that this has strong echoes of Terra’s UST, which collapsed in spectacular fashion after trying to influence the borrow and lend rates on its own coin. The danger here is that there is no real-world case where a currency issuer has simultaneously held a fixed exchange rate (to $1 in this case) while also choosing interest rates (rather than following the market rate automatically as other Aave markets do). In an environment with strict capital controls, this is possible for a long time, but GHO will presumably not exist in a world where Aave can institute capital controls such as freezing, burning, etc.
Further complicating this problem is the ability for stkAAVE holders to receive a preferential discount to the cost of borrowing GHO. The implications will take some time to understand, but this provides a reflexive element to the backing of GHO, where independent of the value of stkAAVE, the borrower can receive a discount.
As a final land mine, the intent to franchise out the minting rights of GHO to various parties chosen by Aave governance means that GHO will only be as secure or stable as its weakest issuer. Even if limits on GHO minted are in place, Aave DAO will need to be prudent in which parties are authorized to do so. The multi-chain approach of GHO being minted across all Aave instances does also increase systemic risk significantly. The recent close call with Harmony shows how easily one market could contaminate all others once GHO is deployed.
Quite frankly, Aave’s poor risk management practices — a Safety Module that relies upon stkAAVE holders to slash themselves benevolently via a manual vote or its risk professionals liquidating users unintentionally or V3’s now-patched oracle vulnerability are all good examples — that suggests the DAO will need to prioritize risk management before granting minting rights to any proposed GHO facilitators.
The Conclusion Based On What We Know
The premise of a lending platform creating a stablecoin holds a lot of promise and there are strong synergies between issuing a stablecoin and provision of borrow/lend services. Aave Companies are quite savvy to realize this fact and move to act upon it.
History has shown that it’s quite difficult to deliver a stablecoin. Perhaps there are significant mitigations that have not yet been announced, but the information at hand suggests GHO will struggle to achieve a stable price. Over the long run, the policies chosen by manually setting the interest rate will become the most important factor, since attempts to artificially increase the monetary base of GHO will result in an eventual choice of de-pegging or collapse as inflation becomes too expensive to offset (see: Thai baht in 1997, Mexican peso in 1994, British pound in 1992, and Argentina and Venezuela today).
So this move to create a stablecoin at Aave is in principle a very strong opportunity, but the implementation details shared in the initial announcement provide a lot of avenues for GHO to fail. Ideally, a system should not rely upon good stewardship or wise leadership. As presented, GHO will lean heavily on facilitators that are honest and competent, Aave DAO’s rates policies being sane and sober, and very efficient markets for borrow/repay arbitrage in real time. That seems like three very steep hills to climb at once.
