Collateral Risk
Context
Given that Chi Protocol uses Liquid Staking Tokens (LSTs) and Liquid Restaking Tokens (LRTs) as collateral, the protocol is inherently exposed to the potential for the value of these liquid derivatives (such as stETH and weETH) to differ from the underlying asset (ETH). In scenarios where the value of the derivative trades below that of ETH, the protocol might have to exchange LSTs/LRTs at a discount to rebalance its reserves. Therefore, it is crucial for Chi to ensure that the price difference between these two assets remains as small as possible. This is achieved by supporting LST and LRT assets with the lowest likelihood of depegging across the industry.
When considering LSTs and LRTs, it is important to explore three key risks, using Lido as an example:
Exploring these risks is essential for understanding the potential challenges that Chi Protocol may face and the strategies required to mitigate them effectively.
1. Liquidity Risk of LST/ETH on Curve
Users' ability to stake ETH with Lido and receive a 1:1 stETH ratio generally ensures that the prices of the two assets do not significantly diverge. However, prices between stETH and ETH could begin to diverge slightly if there is greater demand to stake or unstake ETH/stETH than what is available either via the Lido exit queue or through external markets enabling swaps, such as Curve.
At this point in time, all protocols reliant on stETH (and any ETH LST) accept this liquidity risk profile. This means that the amount of stETH that can be unstaked with Lido might be subject to delay, or users may have to accept a slight discount if they need to trade immediately on external markets.
The stETH-ETH Curve pool is the most liquid source of on-chain liquidity for stETH, with a TVL of approximately $200 million as of September 2024. This liquidity allows any user to swap stETH for ETH if they prefer not to wait for the Lido stETH validator exit queue.
Chi Protocol interacts directly with Lido smart contracts to stake ETH (ETH <--> stETH) and performs automatic rebalancing of its LST/LRT reserves using the stETH-ETH Curve pool (stETH <--> ETH). As of September 27th, 2024, stETH liquidity remains the highest on-chain, with the stETH-ETH pool on Curve holding a TVL of $180 million. This strong liquidity profile supports Chi Protocol’s operations and helps minimise the risk of price divergence between stETH and ETH.
2. Loss of Confidence in the Underlying LST
The loss of confidence in an LST's integrity might occur if a critical smart contract bug is discovered within the LST. In such an event, users would likely rush to unstake or swap out of the LST for alternative collateral as quickly as possible. This could lead to long exit validator queues with protocols like Lido and a significant reduction in liquidity across both DeFi and CeFi exchanges.
Chi Protocol actively monitors the integrity of the ecosystem and other liquidity sources. With capital preservation as a top priority, Chi Protocol would proactively swap from the affected LST to a more stable form of collateral in the highly unlikely event that a critical flaw in an LST's smart contract is discovered and cannot be remediated by the protocol's treasury or its backers.
Lido's stETH has become a more widely used collateral asset than ETH across many of DeFi's major "blue chip" protocols. If a serious issue were to occur with Lido stETH, the entire DeFi ecosystem would be at risk—issues would not be isolated to Lido and Chi alone. In such a scenario, an Ethereum hard fork might be a realistic outcome if Lido and stETH were to collapse.
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