[LEND] MIP12c2-SP2 Collateral Onboarding Risk Evaluation

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Summary Proposed Risk Parameters

Risk Premium: 6%
Liquidation Ratio: 175%
Debt Ceiling: 1 million
Auction Lot Size: 200,000
Minimum Bid Increment: 3%
Bid Duration: 6 hours
Max Auction Duration: 6 hours
Liquidation Penalty: 13%
Dust: 20 Dai

Outline

  1. Overview
  2. Metrics and Analysis
  3. Risk Parameters

Overview

Protocol Summary

From the whitepaper:

“Aave is an open source lending protocol that provides a friendly user experience for anyone to deposit and borrow cryptographic assets. Deposit allows you to earn passive income based on your holdings. Borrow allows you to unlock liquidity without being required to sell your assets. The birth of the Aave Protocol marks Aave’s shift from a decentralized P2P lending strategy (direct loan relationship between lenders and borrowers, like in ETHLend) to a pool-based strategy. Lenders provide liquidity by depositing cryptocurrencies in a pool contract. Simultaneously, in the same contract, the pooled funds can be borrowed by placing a collateral.

Aave Protocol officially launched on the Ethereum blockchain on 9 January 2020, offering instant-access ‘flash loans’ to users without the need for collateral. The predecessor to Aave Protocol was ETHLend which launched in 2017 after raising $16m in an ICO.”

LEND Token Value Accrual

From the website:

The platform has 2 types of fees. Borrowers pay 0.25% of the loan amount during origination, of which 20% is used for referrals and 80% is swapped to the LEND token and burned. For flash loans, a 0.09% fee is collected from the loan amount, of which 70% is redirected as extra income for depositors of the protocol and 30% is split using the same 20%/80% model of the origination fee. Additional transaction fees related to Ethereum blockchain usage are assessed based on network status and transaction complexity.

LEND Token v2

From Delphi Digital:

“Last but not least, they will be updating their token economics and moving from a token burn model to a fee accrual model (something we’ve extensively covered in the past as an option other protocols should consider). While the exact details aren’t out yet, their token (LEND) will be used for staking. Stakers will earn issuance rewards and fees in return for backstopping the risk of the protocol losing funds.This may be ringing some bells for you. This is similar to the MakerDAO model, where MKR is minted in case the protocol becomes insolvent.”

Governance function

The protocol is governed through AragonDAO, but currently only the team has voting rights. These rights entail the changing of parameters such as rates, emergency pause and collateral onboarding. On the Aave discord the team is suggesting an upgrade to a new governance model this year, where LEND token holders will be able to make decisions on the DAO and its risk parameters.

Metrics and Analysis

LEND Token Metrics

Daily Active Addresses

Active address count began to rise in April this year when the Aave protocol started to gain traction. Currently there are around 400 daily active addresses, an uptick likely caused by the recent price performance of the token. Note that LEND tokens are not required to take a loan or make a deposit on the Aave platform.

Source: Saniment

Token velocity

Token velocity measured about 1 throughout the first few months of this year (through the Aave protocol launch), but increased in May when the LEND price experienced significant increase in activity. Some of the recent excitement is also associated with speculation that Coinbase might list LEND in their next batch of new listings.

Source: Santiment

Daily Onchain Transaction Volume (denominated in LEND)

Again, higher transaction volumes in recent months correspond to the price increase. There is between 10m and 30m LEND transacted daily, which is about 1.5% of total LEND supply.

Source: Santiment

Daily New Addresses

New LEND address counts are increasing at a rapid pace, especially during the month of June when more than 100 new addresses were added daily. This explains the huge price increase as new investors discovered LEND as part of the general sentiment shift toward DeFi tokens.

Source: Santiment

Token distribution, return & inflation metrics

The LEND token contract has a limited supply of 1,300,000,000 tokens. According to Coinmarket cap, all of the tokens supplied are circulating and team tokens have already been vested. Note that this token has been in existence since November 2017. The returns over the last two years (and particularly this year) have been impressive but might contribute to a larger downside risk.

Compared to recent token analyses we did for ZRX and KNC, this project doesn’t have as many tokens supplied on exchanges (only one third of supply), as there is only one larger exchange currently supporting it (Binance). On the other hand, one third of supply is locked in the Aave protocol itself as collateral to borrow funds and presents contagion risks (addressed later).

Note also that more than 75% of tokens supplied were acquired in the last year (see seniority distribution below) when the price increased between 400% and 700%, which means the P&L of those holders is high and a sudden drop in token value may force aggressive profit taking. We have witnessed a similar sharp drop of the token price on Black Thursday, when LEND fell in value by more than 60% and had one of most severe drops relative to other tokens analyzed by our team.

token supply 1,298,253,016
circulating supply 1,298,253,016 100.00%
LEND burnt 1,814,675
price 0.094
market cap 122,177,293
implied market cap 122,177,293
returns LEND $ price tokens circulating inflation since
3m 443.29% 0.017322 1,299,364,505 -0.086%
6m 334.26% 0.021671 1,128,353,504 15.06%
1y 790.34% 0.01057 1,115,377,294 16.40%
2y 189.99% 0.032452 1,086,433,933 19.50%

Source: Etherscan & Coinmarketcap

Source: Etherscan

Source: Nansen

Treasury funds

The team may have already diversified its ETH treasury and converted into fiat. It is hard to estimate current holdings in fiat, but a large chunk of ETH was likely sold in the period between December 2017 and February 2018. The team did an ICO in November 2017 when it raised approximately $16m. Assuming a decrease in the ETH treasury corresponds to conversion to USD on the same day, the Aave team has potentially managed to convert their initially raised $16m to about $24m.

Source: Etherscan

Tokens on Exchanges

About 36% of circulating supply is held on exchanges. Of that amount, Binance represents more than 90% of the tokens held on exchanges, which represents a high risk. Some of the figures below may also indicate inaccurate or inflated LEND volumes. On the other hand, this token doesn’t appear to be washtraded very much on other exchanges. Volumes reported on CMC from exchanges that are typically known to produce washtrading don’t appear to be inflated.

Exchange Balance
Binance 416,390,442
Gate.io 18,316,573
KuCoin 17,343,038
HitBTC 4,815,485
Uniswap 4,024,062
OKEx 3,101,438
EtherDelta 2,115,201
Bittrex 634,432
Other 259,987
IDEX 187,714
Kyber 102,020
Total 467,290,392
out of circulating supply 35.99%
out of total supply 35.99%

Source: Nansen

Source: Nansen

Trading data - CEX Volume

CEX volume analyzed includes only Binance pairs with BTC, ETH and USDT. USDT pairs were added just recently in May, and the highest volumes are still reached with the BTC pair. Rolling 30d average volumes measure about $2m, although the high current volumes are mostly due to the recent price increase.

Source: Cryptocompare

Source: Cryptocompare

Trading Data - DEX Volume

The median daily DEX volumes have been trending upwards, reaching new highs in June. On one particular day more than $300k LEND was traded on Uniswap. It will be interesting to note if the increased volume is a short lived phenomenon corresponding to the recent price increase or if it becomes sustainable.

DEX LEND Daily Volume 30d median USD Volume
Uniswap $43.455
Kyber $41.501
0x $0
Balancer $22.016

Source: Protocol trackers

Source: Uniswap v1 volumes for LEND

Volatility

hourly yearly
90d vol 1.67% 156.21%
1y vol 2.07% 194.09%
2y vol 1.85% 172.81%

Source: Cryptocompare

Downside risk

Drawdowns for LEND are much more frequent than for ETH, which makes sense given the massive price rise observed over the last year. As noted before, the price on Black Thursday fell by more than 60%.

Source: Cryptocompare

Correlation with ETH and BTC

LEND correlation with ETH is 0.63 over the last two years, but correlation of negative returns is 0.83.

DeFi Presence (LEND used for lending, integration with other protocols)

  • $44.8m Lend supplied to Aave, $66k borrowed
  • $220k liquidity on Uniswap v2 and $540k on Uniswap v1
  • Integrations:
    • Instadapp
    • Curve
    • 1inch
    • SetProtocol (used as collateral)
    • Uniswap (liquidity + tokens used as collateral)
    • Synthetix
    • DeFi Saver

Aave Protocol metrics

Supply and Borrow Volume

Borrow volume on Aave was increasing at a similar pace (and wasn’t far behind) as their competitor Compound, until the recent COMP distribution where Compound borrow volume increased from $19m to $750m in just a few weeks.

Source: DeBank

The ‘Total Deposits’ metric was significant for Aave as it breached $100m in assets in mid June. Aave’s ability to grow quickly and stay competitive with Compound was due to aggressive policies such as including additional collateral assets in the protocol, setting competitive rates and enabling unique products such as flash loans, Uniswap LP collateral and stable rates.

Source: DeBank

Unique Lenders

The daily unique lenders metric measures about 250 and is in an upward trend.

Source: Dune Analytics

Origination Fees

The Aave protocol primarily generates revenue through origination fees, which corresponds to steady borrow volume growth.

Source: Dune Analytics

Fees burnt

Apart from origination fees, the protocol also generates some revenue from flash loan fees. These fees, however, represent less than 5% of the total. All fees are then used to burn LEND tokens, and so far about 2m LEND tokens are supposedly burnt (or queued up to be), covering the 6m period since the protocol has been live. This represents only 0.15% of the total supply and puts the APY of LEND at 0.3%. Note however, that this metric is somewhat downward biased since it includes the smaller borrowing activity of the first few months (compared to the current state).

Source: https://burn.aave.com/

Liquidity breakdown

As seen below, Aave collects fees from two kinds of markets: Aave market and Uniswap market, where Uniswap LP shares are provided as collateral. Most of the fees collected are represented by Aave market variable rate borrowing, where total originated fees amount to $118k and out of this $88k was collected so far.

Source: https://aavewatch.now.sh/

Flash loans

Flash loans are the unique feature that put Aave on the DeFi map earlier this year. More than 3.6m DAI has been flash loaned already. Although this service isn’t producing a very high amount of fees for the protocol, it has become an important feature for integrated service providers such as DeFi Saver which uses flash loans to build leverage on MakerDAO or perform collateral swaps with higher liquidity and capital efficiency.

Source: https://aavewatch.now.sh/

Lending Activity

As we would expect, most of the borrow volume is associated with stablecoins such as USDC, USDT and DAI.

Source: Our Network Newsletter

Fee repayments

The ability to collect fees is quite important and Aave has been quite successful in this. Only the USDC collateral type has more pending fees than collected.

Source: Our Network Newsletter

LEND supply on Aave

Roughly 45% ($75m out of $167m) of the total supplied collateral on Aave are LEND tokens. Protocol tokens typically are not the most robust collateral and represent a risk, although we note that the collateral factor is set to a conservative 40% LTV. We analyzed the top 3 LEND suppliers who represent 80% of the LEND collateral to assess how much debt was issued against it. The largest supplier represents 60% of the LEND supply pool ($45m of LEND supplied) and borrowed ~$5m of other assets. Even though collateralization levels are fairly high, the debt borrowed by these three entities amounts to $7.9m which is about one third of total borrows on Aave. On the other hand, these entities also supply other assets and don’t appear to be solely monetizing their large LEND holdings that might be harder to sell on the market.

Top 3 LEND suppliers on Aave

0x5d31…2328 0xEd0b…d2CE 0xe3786…A239 Top 3 total
LEND collateral $45,118,215.06 $10,924,723.45 $3,206,448.09 $59,249,386.60
Other collateral $2,478,701.25 $2,967,427.94 $11,035,215.15 $16,481,344.34
Debt $4,978,118.47 $800,330.78 $2,131,479.27 $7,909,928.52
Total Debt Aave $24,545,500.43
Share 32.23%

Miscellaneous

  • Security:
    • From their website: Currently, the protocol code has been audited by Trail of Bits and a second audit by OpenZeppelin prior to the release of the protocol during September and November of 2019 respectively. In May 2020, prior to the release of the Uniswap Market, Consensys Diligence audited Aave’s Constant Product Market Price Provider (CPMPP) Component.
  • Bug bounties up to $250k https://aave.com/bug-bounty
  • Admin keys: Team’s multi-sig have access to admin keys which can perform change of parameters including pause function.
  • Legal status: Due to lack of relevant expertise, we choose to omit any legal risk analysis surrounding either the protocol or the token. However, we encourage the community to incorporate this risk into the risk management process accordingly.
  • Oracles:
    • From the website: First checking for a price from a Chainlink aggregator.
      • If the price is below or equal to zero, we call our fallback price oracle.
      • The fallback price oracle is currently maintained by the Aave team.
  • In the future, Aave governance mechanisms will manage the selection of sources and the fallback price oracle.
  • Risk Framework:
    • Risk Framework addresses mostly if the asset is included as collateral to borrow on top and what kind of LTV and liquidation penalty is used. Approach used is very simplified but transparent: https://docs.aave.com/risk/

Summary of Notable Risks:

  • More than 90% of the CEX volume is on Binance.
  • DEX volume is improving, but still far behind CEX (even using recent daily traded record figures of $300k, it is still low compared to Binance’s recent average of $2m)
  • We are unaware of a new governance mechanism that is to be announced soon according to their team. Further there are rumors of a v2 that will launch sometime this year which might have similar token economics as MKR.
  • General risks with secondary lenders where aggressive policy of adding new collateral is performed and lack of instruments to limit exposure (no debt ceiling, for example). There are also risks known to secondary lending venues such as bank runs and the inability to redeem supplied funds. Aave has been an innovator in the DeFi space with the addition of unique collateral types and flash loans, but unfortunately this means risk management has increased in complexity.
  • Further, secondary platforms don’t have an insurance buffer attached. Although this actually means LEND tokens don’t have to worry about dilution, if they suffer a loss they could lose users’ trust.
  • Contagion risk is quite severe as the LEND token is itself used as collateral. In case LEND tokens might one day get used as insurance against losses, they shouldn’t be part of the collateral pool. Furthermore, the top 3 LEND suppliers to Aave represent about one third of all borrows.
  • The current speculation surrounding DeFi is making DeFi tokens overvalued in relation to their fundamentals. For instance, Aave was able to collect approximately $100k in fees this year, but the token’s market cap is ~$160m.
  • Hence, downside risk is very high accompanied by a large number of token holders that acquired LEND in the last year and made huge returns. We have evidence from Black Thursday that the asset is prone to large dumps in volatile market events (dropped more than 60%).

Proposed Risk Parameters

Risk Premium: 6%
Liquidation Ratio: 175%
Debt Ceiling: 1 million
Auction Lot Size: 200,000
Minimum Bid Increment: 3%
Bid Duration: 6 hours
Max Auction Duration: 6 hours
Liquidation Penalty: 13%
Dust: 20 Dai

We use the model described from the governance call here: a credit risk model that estimates the loss distribution of a portfolio of LEND Vaults. Risk parameters are estimated from this hypothetical loss distribution. Inputs to the model are derived from trading data along with stressed input parameters. A link to our model specification with inputs and outputs can be found here. Auction parameters have been selected to mirror those for ETH, with the exception of the lot size that has been normalized to a ~$30,000 amount

Despite simulating for a 3 - 5m debt ceiling, we are instead proposing a 1m debt ceiling due to the concentrated oracle risk. When LEND is listed on additional reputable exchanges, we will recommend to the governance community that they raise the debt ceiling to 3 million.

Lead Researcher: Primoz Kordez

Sources:
Website: https://aave.com/
Whitepaper: https://github.com/aave/aave-protocol/blob/master/docs/Aave_Protocol_Whitepaper_v1_0.pdf
Developers: https://docs.aave.com/developers/
Flash loans: https://aave.com/flash-loans
Dashboards: https://aavewatch.now.sh/
Bug bounty: https://aave.com/bug-bounty
Dune: https://explore.duneanalytics.com/public/dashboards/duig0czbmnFZzaZOAmeTmC9qlv3bPVCOb5osqMVM
Burn stats: https://burn.aave.com/
Risk framework: https://docs.aave.com/risk/
Risk parameters: https://docs.aave.com/risk/currency-risk/risk-parameters
Rates: https://medium.com/aave/aave-borrowing-rates-upgraded-f6c8b27973a7
ICO data: https://news.bitcoin.com/pr-4/
ICO fundraise: https://etherscan.io/address/0xa8eb8ee66e94f883d764ee55df9da2b3d517a662#analytics

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