Methodology: Isolation Mode

Methodology Scope

Isolation mode is a feature in Aave v3 that limits an asset’s use as collateral in three ways:

• Other assets cannot be used as collateral at the same time
• Only some approved stablecoins can be borrowed
• Total loans against an isolated asset cannot exceed a debt ceiling

Although any asset can be isolated if needed, it is most applicable for assets that have a short track record of use or unknown tail risks. Assets in isolation mode can later progress to a less restrictive listing if market conditions around the asset develop positively.

Methodology Objective

Similar to borrow and supply caps, isolation mode is designed to limit protocol exposure to price volatility and potential insolvencies. While well-tested assets with sufficient on-chain liquidity can be effectively managed with standard parameters, isolation mode is intended as a more conservative option for higher-risk assets. We recommend isolation mode when standard risk parameters are insufficient to list an asset within the community risk tolerance.

Methodology Summary

If we determine that isolation mode is needed to list an asset safely, we go on to recommend an appropriate initial debt ceiling. Generally, the heuristics below are used to set the debt ceiling.

• Circulating supply: High debt relative to the circulating supply of the collateral asset can disrupt liquidation mechanics. We may limit the debt ceiling to a portion of the circulating supply (for example 15%) to support healthy liquidations.
• Share of borrows: A high proportion of borrows against an isolated asset may create excessively concentrated risk. We may limit the debt ceiling to a portion (for example 20%) of borrowable assets to reduce risk concentration.

If the primary purpose of debt ceilings is to protect against non-specific risks of newer assets, a natural progression is to enable the asset outside of isolation mode once it has proven safety, rather than increase the debt ceiling over time. On the other hand, if an asset is proven risky, we aim to delist it rather than reduce the debt ceiling. However, since the debt ceiling is denominated in USD, we may consider an adjustment if relevant metrics change significantly in USD terms. Further, we may consider removing an asset from isolation mode if:

• Users express a preference for more diverse borrowing choices
• The increase in revenue generated for the protocol would be significant
• The asset has demonstrated some level of safety

Methodology Assumptions

• Assets in isolation mode can be reasonably evaluated for safety over time
• The potential benefits of listing newer assets in isolation mode justify the inherent unknown risks within the community’s risk tolerance

Success Metrics

Retroactive analysis of the asset’s history including isolation mode and the attributable risks and benefit