Gauntlet Recommendations: Inter Protocol - New Asset Listing (8/14/23)

Background

Gauntlet's goal with initial asset listings is to ensure that insolvency and liquidity risks are minimized and that when liquidations occur, they can be done healthily with incentivized liquidators. To be unbiased, Gauntlet will not explicitly support any asset listing but instead provides risk recommendations for the community. Gauntlet will assess a given asset's liquidity and other market characteristics to be added to the protocol.

Gauntlet will relay our findings to the IEC and make parameter recommendations for Minimum Collateralization Ratio, Liquidation Ratio, Liquidation Penalty, Mini Limit, etc. For initial asset listings, the parameter recommendations are based on market and liquidity data. After 30 days of user positions developing on the protocol, Gauntlet will provide risk recommendations based on the actual usage data and market conditions using our risk models.

Summary

stATOM stands as the largest LST (Liquid Staking Token) on the Cosmos blockchain, offering users the opportunity to earn PoS staking rewards while retaining their liquidity for seamless interactions with decentralized applications (dApps). In the context of a new asset listing, Gauntlet's primary objective is to mitigate insolvency and liquidity risks while ensuring that liquidations, when necessary, are conducted in a healthy manner.

For the initial listing of stATOM on the Inter Protocol, Gauntlet presents the community with two options for risk parameters: Minimum Collateral Ratio, Liquidation Ratio, and Mint Limit. Option 1 adopts a conservative LR approach with a higher Liquidation Ratio and a correspondingly higher Mint Limit. On the other hand, Option 2 follows a tolerant LR strategy, featuring a lower Liquidation Ratio alongside a reduced Mint Limit. Both options empower the community by providing choices, allowing them to decide whether to prioritize a higher Liquidation Ratio or a higher Mint Limit. These choices aim to minimize risk exposure when listing an initial asset, ensuring a well-considered and secure launch process.

Option 1

Option 2

It’s important to note if it is required for a protocol to increase the liquidation ratio to minimize risk, this action can result in a poor user experience. Therefore, lowering this parameter should be done gradually over time as the market evolves and liquidation mechanisms are thoroughly tested.

General Recommendation

Analysis

What is stATOM?

• In Proof-of-Stake blockchains, token holders have the option to lock up (stake) their tokens to enhance network security. The security of the network is directly correlated to the number of tokens staked. However, this staking mechanism can lead to capital inefficiencies and liquidity challenges for users and on-chain protocols.
• Liquid staking protocols offer a solution to this issue by introducing liquid staking tokens (LSTs) backed by staked tokens. With LSTs, stakers can simultaneously earn PoS staking rewards while utilizing their assets to interact with various dApps, enabling them to earn yields and participate in lending/borrowing activities.
• Among the various LSTs in the Cosmos hub, stATOM developed by Stride stands as the largest.

Metrics Analysis and On-Chain Data Review

Markets
stATOM currently has a circulating supply of 2,380,719 tokens, with a market cap of $26,902,132. This asset is not listed on major centralized exchanges (CEXs) like Coinbase, Binance, or Gemini. However, approximately 46% of its circulating supply resides in the Osmosis stATOM/ATOM pool, ensuring sufficient liquidity for considering this asset as collateral.

Major markets for stATOM

Volatility

The following graph shows the frequency of day-over-day price changes of given magnitudes for WETH and stATOM since stATOM started trading. As shown in the figure, stATOM has more frequent and larger price swings compared to WETH. stATOM's 30D volatility is estimated around 82%, whereas ETH's stands at 66%.

• The maximum daily drawdown for stATOM happened on 11/10/22, when the price crashed 20% from 12.29 to 9.79 as the FTX risk event was happening.
• Given that stATOM is a relatively new asset, its trading history lacks substantial market stress events. Therefore, historical volatility may not reflect its future volatility, requiring IST to take conservative measures for listing this asset.
• The timeseries below show how stATOM’s volatility has evolved since it started trading until June 23 (the chart reflects stATOM’s true price and not the price reflected by Coingecko).

Daily Volume

The chart below shows stATOM’s daily volume on the Cosmos blockchain. The mean daily volume is $100k providing sufficient efficiency to Cosmos DEXs. As shown in the second figure, stATOM’s volume has been trending upwards through this year.

Tail Risks Assessment

• Oracle price deviation: stATOM is a relatively new and smaller asset in terms of volume and market cap. Its limited presence on centralized exchanges (CEXs) exposes it to a higher risk of oracle price deviation or potential exploits.

  • On June 29, 2023, when ShadeSwap was newly listed on Coingecko, a sudden surge in trading volume was observed. This event caused a temporary deviation in reported stATOM's prices. The price of stATOM was inaccurately reported as ~$0.02, instead of the actual ~$10 On Coingecko. This led to the band protocol’s price feed reporting a price of ~$6 for stATOM and hence, liquidation of stATOM vaults on lending/borrowing protocols on Cosmos. The chart below shows stATOM prices as reported on Coingecko.
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  • To mitigate such risks and safeguard users’ vaults, Gauntlet strongly recommends Inter Protocol to prioritize the robustness of their oracle design, especially given the few number of price sources for stATOM. Using median prices and Time-Weighted Average Prices (TWAPs) can significantly reduce the susceptibility of the reported prices to manipulation, ensuring more accurate and reliable data for liquidations.

• Sharp deviation from ATOM: Staking yields are susceptible to Proof of Stake slashing mechanisms, which could lead to rapid declines in the price of stATOM/ATOM. The risk of staked assets depegging introduces additional market volatility for these tokens compared to the base asset (ATOM). However, for the Inter protocol, stATOM is just another collateral asset against IST, therefore this tail risk of depegging is not as significant.

Recommendations

Even though stATOM is a relatively new asset, its substantial on-chain liquidity makes it suitable for listing as collateral on the Inter Protocol. Notably, the Osmosis DEX allows for swapping stATOM to USDC, with a 25% depth representing 132,000 tokens (approximately $800k). The on-chain liquidity from Cosmos DEXs ensures that liquidations for stATOM collateral can be carried out efficiently.

Following a 30-day period of collateral enablement, Gauntlet's continuous parameter tuning process, conducted through simulation optimization, will cautiously explore the possibility of decreasing LR and MCR parameters. This decision will be driven by analyzing actual usage data and current market conditions, ensuring that adjustments prioritize safety and mitigating insolvency risk.

Parameters

General Recommendations

Interest Rate → 2.5%

Our analysis suggests setting the initial interest rate to 2.5%, which aligns with stablecoin borrowing interest rates on other major DeFi lending platforms.

Liquidation Penalty → 10%

The liquidation penalty incentivizes for users to manage their vaults to avoid liquidation. We recommend initializing it at 10%. This penalty is higher than other major platforms in DeFi on Ethereum, as there is currently zero DEX liquidity on the Agoric chain itself. This means that ATOM vaults cannot be liquidated in a single atomic transaction. Liquidators must hold the liquidated tokens for at least the length of a bridge transaction, which adds capital costs and risk to the process.

Minting Fee → $0

The minting fee is primarily a source of revenue for the protocol. It can be initialized at $0 to incentivize users to join IST.

Minimum Initial Debt → $50

The minimum initial debt prevents users from opening vault positions that would be too small to service. Dust vaults that cost more to liquidate than they are worth are effectively dead funds; effectively the same as insolvent collateral. The minimum should be set such that liquidations are always profitable net of transaction costs. We recommend setting it to $50, to be robust to relatively high transaction costs when the chain achieves greater adoption.

Option 1

Liquidation Ratio & Minimum Collateral Ratio

Due to stATOM's relatively high volatility, recent incidents of oracle deviation, and limited price data, Gauntlet recommends a conservative liquidation ratio of 220% for stATOM. This ratio is subject to change as the market evolves, mechanics are tested out and actual user positions develop.

Mint Limit

The mint limit is the max amount of IST that can be minted across all stATOM-backed vaults. We recommend an initial value of $800,000 at recommended LR, as this amount can be safely liquidated via on-chain DEX liquidity without producing enough slippage to become insolvent. This recommended mint limit minimizes losses in an infinite mint attack (and other attacks like oracle manipulation).

Option 2

Liquidation Ratio & Minimum Collateral Ratio

Given the Inter protocol’s strategy for growth, Gauntlet recommends a less conservative LR and MCR recommendations with an adjusted Mint Limit. A liquidation ratio of 200% ensures the protocol would remain solvent in the event of a 40% daily drawdown. (40% represents ATOM’s maximum daily drawdown, and stATOM, which is pegged to ATOM, follows a similar price trajectory) while allowing borrowers to increase their capital efficiency by having higher collateral usage.

Mint Limit

Gauntlet suggests a $600k USD mint limit based on the more tolerant LR recommendations to reduce insolvency risk to the Inter Protocol. This ensures that the lower collateralized positions can be liquidated safely in a severe market downturn and minimize insolvencies. Since slippage could be relatively high for liquidating large positions of stATOM, a mint limit of 600k ensures slippage costs could be covered by these higher collateral usage positions in the event of an extreme market downturn. This recommended mint limit minimizes losses in an infinite mint attack (and other attacks like oracle manipulation).

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