The Tally Newsletter, Issue 68
March 25, 2022
Welcome back for issue 68 of the Tally Newsletter, a publication focused on defi and DAO governance. We’ll keep you updated on key proposals, procedural changes, newly launched voting systems, shifting power dynamics, and anything else you need to know to be an informed citizen.
This week we cover:
Lido’s Expanding Lead in Ethereum Liquid Staking via Aave Integration
Plus brief updates from Tally and the DAO ecosystem!
Lido Sees Surge in Demand Driven by Aave Collateral Usage
TL;DR: The recent addition of stETH to the Aave money market has enabled leveraged staking strategies that have widened Lido’s lead in total staked Ether.
While Lido has long been a market leader within the Ethereum staking space, recent integrations with the Aave lending market have turbocharged adoption and deposit volumes. This has had the effect of widening Lido’s lead in total Ether staked (even exceeding top centralized exchanges such as Kraken and Coinbase), while also significantly increasing systemic leverage and raising key questions about validator centralization. We dig into the recent market moves and potential impacts below.
Aave listing
stETH was initially added to the Aave v2 protocol on Ethereum mainnet at the end of February. This followed roughly several months of discussion in the Aave governance forum, as well as development work to allow the proposed market to conform with stETH’s non-standard rebasing mechanism.
Source: Aave governance dashboard
stETH was listed with a 75% liquidation threshold, which was likely optimized to mitigate price risk of users supplying stETH as collateral to borrow stablecoins. But in the following weeks, we’ve begun to see a different preferred trade take prominence: supplying stETH collateral, borrowing ETH (at a lower rate), and then staking the borrowed ETH back into stETH to increase the total yield earned.
Leveraged ETH staking
With maximum permitted borrowing of up to 70% of collateral value, defi users quickly realized they could potentially earn as much as 3x staking rewards by continuously borrowing ETH from Aave and resupplying stETH. While initial usage was limited, over the past week these positions have exploded and total stETH deposits on Aave now total over $1 billion.
There are also several structured products that are competing to capture this market demand, while abstracting away position management and reducing transaction costs required to establish this position. Galleon DAO and Beverage Finance (two micro-cap asset management protocols) were the first to capitalize with their recently launched ETHMAXY leveraged index product (targetting 3.09x leverage of stETH vs ETH). Larger competitor Index Coop is also planning to release a similar product in the near future.
This huge inflow has helped push up ETH borrowing and lending rates on Aave, from a previous equilibrium of near 0% to around 2.5% for borrowing and 0.4% for depositing ETH. This has reduced maximum expected returns of leveraged ETH staking positions from as high as 12% at launch to current rates of around 7% (still nearly double the 4% base return offered by Lido).
Source: Aave market dashboard
Changing Aave market dynamics and defi risks
This marked increase in ETH borrowing activity could represent a windfall for the Aave protocol in a few ways. First, Aave captures 10% of all interest paid on ETH borrowing positions via their reserve factor. While this is primarily charged to help cover potential loan losses if underwater positions can’t be effectively liquidated, any excess reserves can be captured by the Aave protocol and used for governance approved initiatives (eg. buybacks, investments, payroll, etc).
In addition, interest earned on ETH collateral helps offset the cost of borrowing other assets from the protocol, effectively subsidizing usage across the rest of Aave’s markets. With ETH serving as Aave’s most important collateral asset (primarily supporting users borrowing stablecoins), this source of intrinsic yield could help the protocol wean itself off of liquidity incentives without adversely impacting utilization.
However, this tailwind comes with significant tradeoffs. At $1 billion in stETH collateral and growing, Aave is already exposed to potentially fatal levels of systemic risk if Lido were to be compromised via a hack or governance attack. This could cause contagion across Aave’s other markets, as defaulted ETH loans would impact the true value of aETH used as collateral for a large part of Aave’s loan book. And even a less severe loss, such as a moderate slashing even on Lido’s validators, could lead to market dislocation with forced selling of stETH causing its value to fall far below 1:1 parity with ETH.
Source: DAI Stats
As one of the largest depositors in the Aave market via the DAI direct deposit module, Maker would also face systemic levels of risk from this sort of contagion and default playing out (in addition to the $100 million in direct Lido exposure Maker holds through stETH and steCRV collateralized vault types).
Both the benefits and risks of the stETH integration are likely to be accentuated with a new governance proposal pushed forward by the team at Instadapp (which offers Aave leverage integrations through their smart contract wallet infrastructure). The proposal would adjust the ETH borrowing rate curve (which determines borrow rates as a function of utilization, or percent of the market’s assets currently being borrowed), lowering interest rates to support higher efficiency.
Assuming this proposal is adopted and the ETH market reaches equilibrium around the target rate of 70% utilization and 3% borrowing rates:
Aave’s annualized revenue from ETH would increase from $1.8 million to $9.1 million (without accounting for a likely increase in total deposits in the ETH market, which would further boost revenue)
Aave ETH deposit rate would shoot up from current 0.4% to 1.9%, which would offset up to 3% APR in borrowing costs on a typical position at 50% loan to value ratio
Lido could see around 700,000 ETH in inflows into stETH (a 25% increase in their total deposits from current levels)
So while tail risks are considerable and would only grow with this proposal’s adoption, the payoff is also very high for all involved. So far, it seems most AAVE governance participants are keen to see this go through.
Source: Aave governance dashboard
Consensus and base layer centralization risks
While it has been largely absent from the above discussions, Lido’s dominance in liquid staking is beginning to cause concern about Ethereum base layer decentralization and consensus stability.
While Lido bills itself as a decentralized liquid staking protocol, it still has several points of weakness. Key parts of the protocol including screening acceptable validators is performed via the Lido DAO, which is in turn controlled by LDO token holders. The LDO token has an extremely concentrated distribution, centered very heavily on founders and seed investors, with participation from additional investors later but relatively low free float on the open market.
The validator set has been widened and continues to expand over time, but currently all of Lido’s ETH stake is distributed across only a few dozen professional validators. Certain competitors, particularly Rocket Pool, support less concentrated validator distributions by allowing permissionless entry into the validator set secured by economic incentives, rather than DAO review and participant reputation.
As Lido’s market share grows, it may become more difficult for competitors to break in and gain integrations considering stETH’s immense liquidity network effects. While Rocketpool’s struggles are arguably made worse by their refusal to offer any protocol funded liquidity incentives, the Aave lending integration may help stETH separate further from competitors (users can earn nearly 2x returns through leverage, without relying on Lido funded incentives).
In a market that seems to heavily favor incumbents over challengers, the best strategy for addressing base layer centralization may be focusing on protocol improvements to Lido itself. This also serves as an interesting example of transmission of centralization risk between different layers of the crypto tech stack, with application layer decisions made by DAOs significantly influencing base layer consensus.
In Brief:
Tally News
Find the Tally governance app and resources under our new domain, tally.xyz!
Ethereum Ecosystem
Bridge protocol Stargate Finance launches, with initial token auction fully purchased by Alameda Research in a single transaction:
Teller begins offering unsecured stablecoin loans to Singapore residents using traditional credit scoring:
MakerDAO receives collateral application from US based bank:
Cosmos Ecosystem
Juno core team members and community rally around compromise proposal, removing Juno whale’s voting power while negotiations continue:
Junowhale rejects community compromise proposal, suggesting to maintain status quo where they continue to hold governance power and earn staking rewards:
Other Ecos
Solana based stablecoin project Cash is exploited, with hacker’s return of funds for all users with <$100,000 balance creating difficult conundrum for project maintainers:
Georgetown professor offers framework for crypto-native disclosures:
Thanks for joining us for Tally Newsletter issue 68. Be sure to check out the Tally governance app and join us on Discord for the latest updates!
Anything we missed? New developments or protocols you’d like to see covered? Drop us a line at newsletter@tally.xyz
Best,
Nate, Tally