To increase $INDEX liquidity the INDEX Coop wants to know how acquiring ETH using Aave credit delegation may help.
Here are my thoughts and findings. This is not investment advice and input and feedback are definitely needed. I hope this information can help ideas and conversation around the new area of Ethereum-based credit delegation.
Borrowing a large amount of ETH and matching it with the Coop’s $INDEX reserves could enable a large liquidity pool and avoid the negative effects of selling $INDEX to set up a pool. Greater $INDEX liquidity should provide better availability and lower slippage for larger investors and traders.
Here is an overview of Aave credit delegation, an example, some of the risks involved, and possible next steps.
Aave Credit Delegation overview
Aave credit delegation enables borrowing without collateralization. A depositor can permit borrowing against their invested assets by making an agreement with a borrower and using Aave credit delegation.
An example usage scenario might be:
A large holder of ETH may want to invest their ETH in a savings contract but the savings options are not great because returns for depositing ETH are currently (Jan 03, 2021):
Aave v2: 0.12% APY
Compound: 0.06% APY
Better returns can be found on Aave by delegating credit to a trusted smart contract, person, or organisation – and the borrower does not need to provide collateral.
Delegated credit returns come from the negotiated terms of the loan. It’s worth noting that credit can be taken in a different asset to that which was deposited in the credit vault.
A credit delegation arrangement may benefit the credit provider (delegator) with extra yield on their Aave deposit and benefit INDEX Coop by providing quick access to ETH for a liquidity pool without the need to sell $INDEX reserves.
Getting delegated credit
A delegator must first deposit the assets they want to invest into Aave to get aTokens.
For example, they receive 150 aWETH in exchange for depositing 150 ETH.
The delegator then needs to place the aTokens into the Aave Credit Delegation protocol and choose a variable or stable borrowing rate model.
Continuing the example, the delegator places the 150 aWETH into a Credit Delegation Vault and chooses the variable rate model (currently 1.26% APR (for the borrower)).
The delegator and a borrower should then reach an agreement before opening a delegated credit line from the vault. The agreement can be an off-chain legal document and facilitated through OpenLaw such as created for DeversiFi.
In the example, the depositor and INDEX Coop agree on repayment in 1 year and an APR of 1.5%. (a rate that may be coverable by returns from the INDEX-ETH Uniswap pool)
The borrower then withdraws however much they want up to the limit defined in the agreement and with consideration to the loan-to-value (LTV) requirements.
INDEX Coop chooses to borrow 100 ETH, match it with 16,866 $INDEX from the treasury, and place them in the Uniswap INDEX-ETH pool. This almost doubles the pool size, helping reduce slippage and enabling larger swaps.
Repayments are on the terms of the loan.
At the end of the 1-year term and in accordance with the agreement, INDEX Coop must repay 101.5 ETH to the delegator. To cover this and not sell $INDEX, fees from the pooled assets would need to have generated around 3% APY.
The critical part of making a delegated loan work well is finding a favourable configuration for both the depositor and the borrower.
Covering the repayment terms of the loan is a risk that is difficult to define. It may be necessary to sell $INDEX to cover the loan if the liquidity pool is not providing returns that can cover the repayments. For example, the DPI-ETH pair averaged a 3% APY from fees over the last two days but other pools have lower returns and some much more.
The delegator could remove unused funds from the vault at any time and prevent more withdrawals.
If a borrowed asset is placed in a liquidity pool, there is an impermanent loss risk which may affect returns and loan repayment.
Selling $INDEX to cover a shortfall from pool fees might be considered a poor outcome.
Relying on liquidity pool incentive rewards to help cover repayments would be dependent on the length of the liquidity reward program.
The legal agreement must be adequate.
INDEX Coop needs to find willing credit line providers (depositors).
If the INDEX Coop could find a willing depositor, a sum could be borrowed and used in a liquidity pool to increase $INDEX liquidity. It is necessary to ensure that the repayment terms are manageable with the returns from the liquidity pool deposit, otherwise the setup will cost the INDEX Coop.
If possible, a simulation of a loan might provide insight into whether taking a delegated credit line is a good idea for INDEX Coop and increasing $INDEX liquidity.
A look at how a loan and pool may have performed over the last 3 months would provide valuable insight.
A target amount for borrowing should be determined. Things to consider:
Minimizing slippage for median swap size demand (Uniswap says median swap size across the platform is $634)
Should INDEX Coop insure the loan, how much is INDEX Coop prepared to pay?
Would using one pool be preferable to many pools and protocols?
How might L2 pool usage change the environment?
How does anyone see Aave credit delegation providing an opportunity for the INDEX Coop?
Sorry for the lack of links, I am new poster and limited.