The discussion primarily revolved around the proposals by Aave Companies and Llama to list LP tokens as collateral on Aave. Pauljlei provided an in-depth analysis of the market risks associated with this proposal, emphasizing the complexity of choosing collateral factors and loan-to-values for these assets due to the nature of arbitrage against these assets¹. He presented two main cases to consider: borrowing asset A against asset A/B LP shares and borrowing asset C against asset A/B LP shares, explaining the risks and considerations for each scenario¹.

In the first case, Pauljlei highlighted the increased risk to the protocol when borrowing asset A against asset A/B LP shares, due to the non-linear function of arbitrage loss and the impact of liquidations of LP shares on liquidity¹. He concluded that collateral factors on A/B LP tokens should be the minimum collateral factor of A and B AND discounted because of the expected impermanent loss¹. In the second case, he explained that borrowing asset C against asset A/B LP shares can present more risk than the first case, due to the liquidity of both A for C and B for C and the impact of cross-asset correlations¹.

The discussion also involved a detailed explanation of the complexities of borrowing against LP shares, with Pauljlei suggesting that CFMM collateral factors should be lower than any of the associated collateral factors until stability is observed¹. Yaron questioned the need to understand/analyze all these losses, rather than just analyzing the LP token as a black box with 50:50 holdings and ignoring the fees⁴. However, Pauljlei emphasized the importance of understanding the impermanent loss function and loss vs. rebalancing of the LP tokens for tuning risk parameters for Aave³.

In conclusion, the discussion underscored the complexities and risks associated with listing LP tokens as collateral on Aave. It highlighted the need for a deep understanding of the dynamics of LP shares, the impact of arbitrage, and the importance of carefully choosing collateral factors and loan-to-values. The discussion also emphasized the need for further research and modeling to ensure the stability and security of the protocol.