Collateral Factors: How to Win the Lending Race

Ideas
12

Gauntlet appreciates the initiated discussion and here we would like to add quantitative considerations around Collateral Factors. Gauntlet recommends that modifying Collateral factors (CFs) without robust fallback measures can expose the protocol as well as the users to larger risk surface area. This is also why we recommend Compound to maintain a buffer between the Liquidation Penalty (LP) and the Liquidation Factor (LF), ensuring an extra margin of safety against rapid price drops or price-feed anomalies. This is specifically true as seen during the market events of Jan 2024 and Aug 2024.

1. Absence of a kill-switch

Aave’s success with higher CFs (or LTVs) partially hinges on its ability to trigger an on-chain emergency shutdown (kill-switch) if extreme volatility (caused due to slashing, etc) or manipulation arises. Compound, however, has no comparable feature. While governance can pause or upgrade markets, these processes are manual and less efficient in terms of response time, offering less agility in crisis scenarios. Without a rapid-response mechanism, drastically raising CFs could leave Compound more vulnerable to liquidation spirals, oracle exploits, or market shocks.

Gauntlet recommends that the pause functionality should be implemented as new “kill-switch” functions in smart contracts similar to Aave, and/or added as assertions directly in the smart contract business logic that can pause certain market functions based on the deviation between LSD and market prices.

2. Lack of Correlated-Asset Price Oracles

Aave relies on specialized oracles that track price movements among correlated assets (such as ETH and various LSDs) which counteract the possibility of sudden, artificial spikes in the staking rate of a correlated asset. The Correlated-Asset Price Oracles helps prevent scenarios where a compromised oracle feed could artificially inflate the exchange rate. Such an event could otherwise lead to a large accumulation of bad debt. By contrast, Compound’s standard oracle system evaluates each asset independently, lacking mechanisms to detect when two assets lose correlation. This shortcoming makes broad-based high collateral factor settings inherently riskier.

The below example runs through a scenario of upward depeg caused by artificial volatility in staking rate.

Upward Depeg by 10%

  1. Initial Setup:

    • User supplies $1,000,000 worth of ezETH ($3,500 per ezETH).
    • Collateral Factor (CF) for ezETH is 88%, allowing a maximum borrow amount of $880,000 or 220 wstETH ($4000 per wstETH) at an exchange rate of ~1.142.

  2. wstETH Exchange Rate is artificially increased by 10%:

    • User borrows $880,000 or 220 wstETH when the exchange rate is 1.142.
    • At 1.256 WETH/wstETH, the value of the borrowed amount increases to $967,120.

  3. Absorption and Liquidation:

    • User is absorbed due to the increased liability.
    • Collateral (ezETH) is taken by the protocol.
    • With a Liquidation Penalty (LP) of 6%, the user is owed $1,000,000 * (1 - 0.06) = $960,000 or 240 wstETH.
    • Store Front Price Factor (SFPF) is 97%, so the value of collateral sold is $1,000,000 * 0.97 = $970,000.
    • Since the collateral is sold when wstETH is 1.256 (~$4400 per wstETH), the protocol receives $970,000 / 1.256 = 220.45 wstETH tokens.

  4. Repeg and Protocol Losses:

    • Upon repeg, the 220.45 tokens are now worth $881,800.

  5. Shortfall Calculation:

    • Liability: $967,120.
    • Value from collateral sale: $881,800 or 220.45 wstETH.
    • Total shortfall per user: $967,120 - $881,800 = $85,320.

  6. Multiple Users Example:

    • If 10 users each exploit this:
      • Total borrowed wstETH: 10 * $967,120 = $9,671,200.
      • Total collateral value after liquidation: 10 * $881,800 = $8,818,000.
      • Total shortfall: $9,671,200 - $8,818,000 = $853,200

Given the above scenario, a Correlated Oracle Price framework would cap the inflated staking APRs while the kill-switch would trigger an on-chain pause across various functions on the protocol.

3. “Soft E-Mode” Already Exists in Compound V3 (Comet)

Compound V3’s WETH Comet is effectively a borrow-only market, where users can supply a small set of correlated or high-quality assets as collateral to borrow WETH. This structure is already a “soft” E-Mode, but more restrictive than Aave’s multi-asset approach. A full-scale E-Mode in Compound would require allowing the base asset (WETH) to be used both as collateral and the borrowable asset—necessitating sweeping architectural changes.

Furthermore, adopting Aave’s E-Mode is not only incompatible with Compound’s single-borrowable-asset model but could also manifest more risk to the protocol considering the present liquidation mechanism. Implementing many-to-many lending would fragment reserves with the Comet’s inability to pay the borrower back due to a high degree of fragmentation.

4. Rationale for lower CFs and LFs for osETH

It’s important to note that osETH relies on a market rate oracle, which necessitates deliberately lower Collateral Factors (CFs) and Liquidation Factors (LFs) to account for the inherent volatility between osETH and WETH. Consequently, this design makes leveraging osETH capital-inefficient, as the lower CFs and LFs impose tighter constraints to mitigate volatility risks.

Recommendation

While Aave’s E-Mode is effective for its particular ecosystem—enabling higher leverage through correlated-asset oracles and kill-switch safeguards—Compound V3 has neither the mechanism to detect artificial deviations from staking rates nor the rapid-response tools necessary for such an aggressive risk posture. If the community wishes to seek higher CFs, we recommend that the protocol implement a 1. Implementing an on-chain kill-switch and 2. Developing robust correlated-asset oracles

We believe these adjustments provide enhanced protection for the protocol to enable more aggressive CFs while avoiding the disruptive changes and additional risks associated with implementing e-mode. Given the absence of these protective mechanisms, Gauntlet is not comfortable increasing collateral factors higher in these markets at the current market conditions. However, if the community still wishes to enable higher Collateral Factors we suggest implementing a snapshot vote to gauge preference.

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