What’s Up With DeFi Before Merge?

Rick and Morty Meme on Ethereum Merge

The Ethereum Merge is a cryptocurrency event that will significantly change the way Ethereum operates. With this hard fork, Ethereum will operate on a new consensus mechanism “Proof of Stake (PoS)” from the originial “Proof of Work (PoW)”. It will also have an impact on the narratives surrounding ETH. The debate on ETH’s eco-friendliness shall take a new turn making it more ESG compliant, along with its utility as a long term debt (if you consider it as a bond). In this article, we shall cover the important proceedings taking place at various decentralized finance (DeFi) governance forums. We will not go into the intricacies of the merge as there has already been a considerable amount of debate and writing on the topic. This article is based on findings by our DeFi researchers Akhil Vajjhala and Jack, and has been edited for relevancy and readability by 0xlol.

Some Useful Resources to Learn about the Intricacies of ETH Merge:

On the Merge. Quick Takes | by Amber Group

What to Expect from Ethereum’s Merge Upgrade | Galaxy — Engineering a new economic paradigm.

A Step-By-Step Overview of Ethereum’s Merge Upgrade and Associated Risks | Galaxy

ETHEREUM MERGE — The Most Anticipated Event In Crypto Explained

Lido

Lido offers liquid staking for ETH holders who wish to earn yield on staked ETH2.0, but do not hold the required 32 ETH required in order to run a full node to stake their assets. Lido lowers the bar to entry for staking ETH, and provides stETH (a liquid derivative of staked ETH) that users can utilize within other DeFi protocols.

Lido is one of the most important pieces of the puzzle when we discuss the Ethereum Merge. It is concerned with the process of liquid staking, and has an important role to play when it comes to impact of the merge on ETH stakers in the PoS.

LIP-12: On-chain part of the rewards distribution after the merge

The Lido protocol upgrade that re-stakes newly appeared rewards after the Ethereum Merge will happen to achieve compounding rewards.

This proposal proposes to re-stake all collected execution layer (EL) rewards while minting only the protocol fee (10%) stETH as part of the beacon chain rewards distribution run. But doesn’t mint/distributes any protocol fee on the non-profitable Lido oracle report.

Distribution Mechanism should work as follows:

  • Node operators collect ether-nominated execution level rewards on a dedicated vault contract. To be precise, MEV rewards could be collected in such a vault contract.
  • The Lido contract withdraws all collected rewards from the vault, re-stakes it and mints new stETH only for protocol fee (10%) as part of the beacon chain (or consensus layer, CL) rewards distribution run.
  • In case of the non-profitable Lido oracle report, don’t mint any new stETH (i.e. the protocol fee).
  • The proposed way brings compounding rewards, has a fast shipment time due to little impact on the existing distribution scheme. It’s also reasonably automated and self-governed. And finally, it falls back to the already adopted solution in case the Merge hard fork is delayed.

Ethereum consensus rewards analysis

  • Main goal: To measure if any client is consistently generating more block proposer rewards.
  • Proposes to develop a custom piece of software that is able to get block proposals from all the clients at each slot and evaluate its score. The idea would be to store these blocks in a database and analyze them offline. Creating a fork of vouch (validator client) that collects the block proposal of each client and scores each of them, which should objectively output which blocks would give a greater reward.
  • Will test if operating validators in different parts of the world could impact their performance. Hence, will monitor how latency impacts block proposal rewards, and whether the same client performs differently in different locations.
  • Will analyze: What votes does an attestation have? Which aggregations should better be chosen to be included in the block proposal in terms of rewards?
  • Every epoch (6.4 minutes) a validator proposes an attestation to the network. The attestation is for a specific slot in the epoch. The purpose of the attestation is to vote in favor of the validator’s view of the chain, in particular the most recent justified block and the first block in the current epoch (known as source and target checkpoints) — what votes are necessary?

Airdropping Fork Tokens & Protecting The Peg:

  • If there is any airdropped ETH PoW to ETH stakers, it will be returned to the underlying holders of stETH.

Lending

AAVE

AAVE is a decentralized lending market, with borrow and lending yields based on the utilization rate (amount borrowed / amount deposited for lending).

Given that the merge is a perfect opportunity for either PoW airdrops or simply hoping that the merge hasn’t been priced in yet, leveraging your position and adding more ETH seems the move for most crypto investors.

However, there are quite a few issues with this:

  • If there are any Merge-related issues -> ETH price falls -> mass liquidations occur.
  • Aave lends user collateral -> issues with Merge -> both Aave and users get badly affected.

Aave’s borrowing limit has decreased, its fees have increased — until ETH borrowing has been suspended entirely until the Merge is complete.

Technical analysis Aave <> Ethereum’s PoS Merge

  • Claims the merge should not affect AAVE’s systems
  • Block structure: Not affected.
  • Block time: Only Aave governance is slightly affected (voting duration).
  • Smart Contracts: Aave is not affected.
  • Sources of on-chain randomness : Not affected
  • New concepts of safe head and finalized blocks (underlying change in Ethereum finality): Aave could be slightly affected, but not on smart contracts.
  • Spoke with Chainlink, and their stand will be with PoS chain — Chainlink will not integrate in Ethereum PoW forks, it will fully commit to the PoS Chain; this ensures that there aren’t any issues with oracles and data

AAVE ETH PoW Fork Risk Mitigation Plan:

Most tokens, excluding ETH, will likely be worthless on an ETHPoW chain. Hence, a strategy which users may employ to maximize their cryptoasset holdings, will likely be to borrow as much ETH as possible (collateralized mainly by stablecoins or other tokens).

In addition, flows from stETH holders to ETH should also be observed, since stETH will likely also be worthless on an ETHPoW chain.

Speculative strategies related to the PoS merge and the potential ETHPoW fork will likely have implications for Aave, particularly because Aave enables ETH to be borrowed from stETH. stETH collateralised ETH borrowing has become a popular strategy, and has increased ETH market utilization to a level of 62% at the time of writing.

Risks related to the ETH market becoming increasingly utilized:

  • High ETH utilization potentially makes liquidations harder or impossible.
  • In a situation where the ETH market becomes heavily utilized and markets start experiencing high volatility as a result of the merge event, liquidations of regular ETH long/stablecoin short positions might not be possible.
  • This will be due to the fact that liquidators will not have access to ETH as collateral since the majority of ETH will be borrowed.
  • This could in turn lead to some positions becoming uncollateralized.
  • High ETH utilization increases the ETH rate to a level where stETH/ETH positions are making negative APY.
  • Once the ETH borrow rate reaches 5%, which happens shortly after 70% utilization rate (we are at 63% right now), stETH/ETH positions start becoming unprofitable.
  • Currently, borrowers on Aave are not leveraged maximally due to depeg risks. As a result, it is possible that some positions will have their APY negative much earlier. This will cause users to unwind their positions up until the ETH borrow rate reverts to a stable level where the APY becomes tolerable.
  • This means that we would see a lot of stETH to ETH redemptions, and in turn a downward push on the stETH price. It will already be under pressure due to regular stETH holders switching to ETH to gain upside on ETHPoW work.
  • Already high ETH utilization causes regular ETH suppliers to start withdrawing their ETH.
  • As a result of the uncertainty and risks related to the ETHPoW fork (and PoS merge in general, and ETH utilization on Aave in particular), current liquidity providers may become increasingly worried about their ETH on Aave, and in turn, may withdraw ETH on the supply side.
  • The utilization rate would increase unrelated to ETH borrowers.
  • Also, if ETH price drops then ETH long/stablecoin short positions will likely need to be deleveraged by selling supplied ETH.
  • This is why ETH borrowing has been frozen.

Alternative: Increase the variable borrow APR at 100% utilization from 103% to 1000%

AAVE DAO stance on Ethereum PoW fork

  • This ARC calls for the Aave DAO to commit to selecting the Ethereum Mainnet running under the Proof of Stake consensus over any Ethereum fork running an alternative consensus (such as Proof of Work).
  • The ARC will formally signal that Aave DAO deployment will occur solely on Ethereum PoS.
  • Authorizes the Community Guardian to take the necessary actions to shut down Aave Deployments on any forks arising from the Ethereum Paris Hard Fork (the Merge).

AAVE snapshot vote:

  • Proposes to Limit ETH borrowing approaching merge

Compound

Compound is a lending market very similar to AAVE, but with less available assets for borrowing. It exists solely on Ethereum, while AAVE has gone multi-chain.

Adjust ETH Interest Rate Model

Update the cETH interest rate model to a new jump rate model with the following parameters:

  • Rate at 0% utilization: 2%
  • Optimal utilization (kink point): 80%
  • Rate at optimal utilization: 20%
  • Rate at 100% utilization: 1000%
  • Set a borrow cap for the cETH market of 100,000 ETH.

Dexes

Bancor

Bancor is a decentralized exchange, enabling users to swap between tokens. Its unique value proposition is the ability to provide liquidity to the dex without facing impermanent loss through its native BNT token, however this has come under fire recently due to poor performance in the recent bear market where users did face impermanent loss.

Proposal: Determine action in the event of a PoW Fork — LEVEL 1 Under Review — Bancor Governance Forum

  • Proposal to disable Bancor contracts on all PoW forks
  • Disabling Contracts:

This option would include disabling all Bancor platform functions on an Ethereum fork. This option should incur little to no risk. The main argument for this is that most tokens on a proof of work fork will quickly become worthless, which would result in the Bancor platform being drained of any value that could be extracted on the forked chain.

  • Do Nothing:

Taking this option: nothing would be done in the event of an Ethereum fork. This would incur no risk to Bancor on Ethereum Mainnet, however, any value that could potentially be extracted from an Ethereum fork would be quickly lost.

Derivatives

Synthetix

  • Synthetix will suspend all Synthetix contracts on both Ethereum and Optimism, around 3 hours before the expected merge block and resume activities after ensuring that Chainlink feeds and the rest of the protocol are stable.
  • The SNX token will still be transferable, but all other parts of the protocol, such as synth exchanges, futures, loans, staking (claiming, mint, burn), and bridging will be suspended. Once the suspension is complete, communications will be made on all proper channels, and all protocol partners will be informed.

Algo-Stables

Frax

[FIP — 101] Make FRAX stablecoins only redeemable on PoS ETH

  • Sam Kazemian (FRAX’s founder) has submitted a proposal for the project’s stablecoin to be redeemable solely on the Ethereum proof-of-stake (PoS) mainnet.
  • FRAX will reject any Ethereum PoW fork.
  • While this is a step towards an Ethereum PoS future, it may create FUD amongst Ethereum PoW users.

Stablecoins (CDPs)

MakerDAO

Risk and Market Impact Overview

Futures Backwardation and Negative Funding

  • Spot holdings of ETH would receive any POW forked tokens, while exposure to ETH quarterly futures or perpetual contracts would not. Assuming efficient markets, this means that quarterly futures after the expected merge date should begin to trade at an additional discount with respect to ETH, based on the expected value of POW fork tokens.
  • Recently, we’ve seen the December 2022 quarterlies flip from premium to backwardation, which reflects the possibility of a POW fork accruing some ‘saleable value’. In practice, market participants can purchase spot ETH, and then sell an equivalent amount of ETH futures to wager on fork value while remaining delta neutral. As the expected date of the merge draws closer, we may see some similar activity on perpetual contracts, with significant discount and negative funding reflecting the expected value of POW forked Ether.
  • Impacts on Maker:

Nominal cost of leverage through futures contracts (excluding potential fork value) declines, creating competitive pressure vs Maker vaults.

Users who consider market implied fork value to be too high are incentivized to leverage on futures, while those considering lower implied value may prefer leveraging with Maker vaults (where the vault owner will still receive any potential fork tokens).

  • Responses:

Maintain competitive rates to avoid losing too much volume to futures contracts.

stETH Discount

  • stETH and other liquid staking assets are likely to become worthless on any POW Ethereum fork.
  • As a result, the market price of liquid staking assets may decline based on the expected value of a POW forked ETH.
  • Impacts for Maker:

Nominal cost of leverage through futures contracts (excluding potential fork value) declines, creating competitive pressure vs Maker vaults.

Users who consider market implied fork value to be too high are incentivized to leverage on futures, while those considering lower implied value may prefer leveraging with Maker vaults (where the vault owner will still receive any potential fork tokens)

  • Responses:

Monitor stETH liquidity and respond with parameter changes (increasing stability fee or liquidation ratio) if necessary

Monitor competitive rates using ETH collateral across defi lending protocols

External Asset Fork Choice

  • Ethereum hosts a broad variety of externally backed assets. This includes cross chain bridges, centralized stablecoins, and real world assets (RWAs). Because these assets are backed by extrinsic collateral (either held off chain or on another chain), they can only be fully collateralized on a single chain at a time and the issuers will generally need to recognize one chain as canonical during a fork.
  • The merge upgrade has strong support across the Ethereum community, DeFi users, and protocols, which should help ensure that fork choice is unanimously in favor of mainnet (POS) Ethereum. However, there is some level of risk that one or more external asset issuers could recognize a PoW fork, motivated by financial exposure to miners or other reasons. This could render relevant assets bridged into mainnet Ethereum worthless.
  • Tether in particular has been raised as a possible risk, due to potential financial ties with miners.
  • Impacts for Maker:

Minimal impact if all externally backed asset issuers support merge upgrade

If one or more issuer supports POW fork, this could cause significant impact to DEX liquidity pools and other protocols accepting the asset as collateral.

  • Responses:

Confirm merge support from key external asset providers that interact with Maker protocol, including: Circle, Paxos, Binance, Bitgo, Gemini, Centrifuge issuers, other RWA issuers, and services bridging DAI out to other chains (eg. Wormhole, Axelar, Gravity Bridge, Multichain).

Liquidity Pool Protocols

  • Maker does not make user collateral available to be borrowed, while many other lending protocols including Aave, Compound, and Euler do. In the aftermath of a PoW fork, a significant subset of assets on the fork chain (including stablecoins and bridged assets) would become worthless instantly. This could cause insolvency in pooled lending markets, and incentivize users to borrow all available ETH in the market (as the one asset most likely to retain some value in a fork).
  • Withdrawals of ETH from liquidity protocols, particularly Aave and Euler, could cause a spike in ETH borrowing costs that would put pressure on leveraged stETH positions and potentially impact the price parity with ETH.
  • Impacts for Maker:

Possible migration of some users from external lending protocols to Maker vaults.

Possible withdrawals of ETH from lending protocols putting pressure on stETH.

Potential for decline in decentralized exchange liquidity for ETH pairings around the merge.

  • Responses:

Monitor user behavior and maintain competitive rates to facilitate any potential migrations or user acquisition.

Monitor stETH leverage positions and ETH lending utilization on Aave, Euler.

Monitor exchange liquidity and consider parameter changes if needed.

Oracle Networks and Indices

  • Maker and other oracle networks like Chainlink are planning to support the merge and consider mainnet (POS) Ethereum as the canonical chain. However, the possibility of a POW fork complicates this somewhat, with heightened possibility of faulty data due to potential centralized exchange issues or ticker collisions.
  • Impacts for Maker:

Increased possibility of bad / outlier data delivered to oracle feeds.

Possibility of market disruption due to bad price data incorporated in 3rd party oracles or perp indices.

  • Responses:

Confirm centralized exchange plans with respect to PoW fork listing, tickers, and API changes.

Encourage industry players to adopt alternative ticker for any POW fork, avoid collisions, and ensure continuity of mainnet Ethereum data

Network Downtime

  • The merge is arguably the largest upgrade in Ethereum’s history. With this significant protocol change, comes increased risk of technical faults that could potentially cause liveness failures and unavailability. If Ethereum goes down for a period of time, defi protocols like Maker could experience price gaps (discontinuous price drops) in collateral assets that could push vaults into liquidation or even insolvency.
  • Impacts for Maker:

Increased risk of downtime and liveness faults around time of the POS merge.

Possibility of negative price gaps during any network downtime.

Reduced ability for users to deleverage or defend their vault positions.

  • Responses:

Consider parameter changes to increase margin of safety on vault positions (e.g. raising liquidation ratios, increasing stability fees on higher leverage vault types).

Encourage users to increase their own margin of safety against liquidations in the lead up to merge upgrade.

Replay Attacks

  • Replay attacks allow for a transaction or message signed on one chain to be “replayed” on another chain in certain cases. Ethereum users (and even custody or infrastructure providers) may fall victim to so-called “replay attacks” in the aftermath of a POW Ethereum fork.
  • While EIP-155 offers a simple protection against transaction replaying by adding chain id as a transaction signature parameter, there is no guarantee that a PoW fork would adopt a different chain-id from Ethereum mainnet (chain-id 1).
  • Impacts for Maker:

Increased possibility of unintended transactions on mainnet, replayed from POW fork chain (eg closing vault positions, selling fork-DAI or fork-MKR tokens, etc).

Possibility of mainnet transactions, including Maker oracle and keeper operations, being replayed to POW fork chain.

  • Responses:

Share info about replay attack risk within Maker community.

Advocate for POW fork to use alternative chain-id (instead of chain-id 1 which will continue to be used by mainnet Ethereum) to avoid replaying transactions.

If your favorite protocol is not mentioned here, it is either because we were unable to find any significant information about it on forums, or we simply missed it (not intentionally).

Credits:

Research and Compilation: Akhil (Twitter) and Jack (Twitter)

Editing: 0xlol (Twitter)

Art:

Illustration: Darshan (Twitter), Conceptualization: 0xlol (Twitter)

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