Simple Summary
In the past few months, Gauntlet has done market risk analysis on the oracle mechanisms used on Compound v3 WETH comet for pricing LST/ETH rates. Our findings compare and contrast the risks of using the LST/ETH Chainlink price feeds to the LST/ETH smart contract rate, and show that there is no immediate need for a change in the oracle mechanism design.
Background
When analyzing mechanism designs of LST/USD oracle feeds of DeFi protocols, we found that in certain cases, there was an asynchronicity between the price updates of BASE → USD and LST → USD, resulting in price fluctuations in LST → BASE feeds. The temporary price fluctuations caused by this asynchronicity can result in unintended liquidations. As a result, for certain LSTs, protocols can choose to use LST/BASE smart contract rate instead of the market rate (i.e. Chainlink feed), where the price of LST is:
which would yield a less noisy price feed compared to
. The cbETH/ETH smart contract rate (found here), is the proportion of all ETH staked + rewards to outstanding LSTs, and updates every 24 hours. Since one can redeem or stake assets into the smart contract at this rate, it is considered the theoretical true price of the LST. In normal market conditions, arbitrageurs will bring the market rate back to smart contract rate using the redeeming mechanism. However, unstaking periods for both wstETH and cbETH are relatively long. wstETH unstaking could take 1-3 days during normal market conditions but it may take significantly longer in market stress situations. For cbETH, one may face a delay of anywhere from 27 hours to as long as several weeks, depending on how many others are unstaking at the same time.By using the smart contract rate, borrowers will have less capital at risk, and can operate with higher capital efficiency. On the other hand, using this rate could increase insolvency risk in LST/Base depegging scenarios.
WETH Comet Oracle Mechanism Design Analysis
The Ethereum Compound WETH market uses the Chainlink (cbETH / ETH)feed. Although more volatile than the smart contract rate, the ETH denominated Chainlink feeds have not triggered unintended liquidations in the past. In fact, the highest price deviation between Chainlink’s cbETH/ETH market rate vs. smart contract rate in the past three months has been 0.0044 (or ~0.44% of the exchange rate), and given the current liquidation curve, such a value does not pose liquidation risk to borrowers. Here is a timeseries of cbETH/ETH market and smart contract rate over the past few months.
Risks of using the smart contract rate for LSTs
- Depegging scenarios: In tail risk scenarios, there could be huge deviations in the smart contract rate and the market rate. During such events, the long queues for unstaking LSTs may prevent the smart contract rate and market rate to converge and lead to insolvent positions on the comet. This situation is exacerbated by the fact that the smart contract rate updates only once every 24 hours and have long unstaking periods. Such deviations could happen in the case of mass slashing, technical risks (e.g. smart contract vulnerability), etc. It’s important to note that in these scenarios, despite the extreme price deviation between the market price and smart contract rate, liquidations would not occur, because the smart contract rate of the LST prices would remain the same.
- Severe dislocations between LST market prices and LST smart contract prices are extremely rare and unpredictable, but the risk needs to be addressed. In order to address such scenarios, there is a need for a mechanism that liquidates high-risk positions before the market drops and stops bad actors from exploiting the pools.
- Custodial risk: There is some level of custodial risk associated with cbETH. Coinbase custody keys associated with the staked ETH underlying cbETH. To the extent these keys are ever compromised, this would likely lead to the underlying ETH they control being lost.
Next Steps
- The LST market rate and smart contract rate deviation has historically been too low to trigger any liquidation on the Ethereum Compound v3 WETH comet, therefore there is no immediate need for a change in the oracle mechanism design. If using the smart contract rate is something that the Compound community wants to explore, Gauntlet can gauge the risk/reward trade-off and provide a follow up analysis if needed.