The Hitchhiker’s Guide to DeFi (Part I) — Lending Protocols & Superfluid Collateral
Disclaimer:
- The above reflects the views of the investor and should NOT be construed as investment advice, financial advice or legal advice.
- This information is purely educational and is NOT meant to be taken as a recommendation to buy or sell any product or service. Please do your own research before making any decisions.
- Where relevant, direct quotes & passages have been taken from the sources, whitepapers, and blog posts mentioned.
Capital markets are ripe for disruption. Decades of high commissions, massive incumbent banking institutions, legacy tech infrastructure, regulatory oversight, and compliance restrictions have stalled growth and innovation in the financial services industry.
Decentralized Finance (DeFi) is the broad term for a collection of open financial systems, enabled by decentralized blockchains, that aim to disrupt the incumbent financial intermediaries by leveraging the power of open-source technology to rebuild financial primitives in a more efficient, transparent, and accessible manner.
The ultimate vision for Decentralized Finance (DeFi) is to build a self-sovereign financial system allowing users to engage in a broad range of economic activities without the need to rely on centralization, trust, and accessibility.
DeFi took off on the Ethereum blockchain primarily because of Ethereum’s high level of composability- the ability to coordinate different parts of a modular & stateless software stack. Composability allows different smart contracts to interact with each other to produce complex financial structures, creating a network of interlinked protocols, or “Money LEGOs”. Composability creates a virtuous cycle and enables powerful network effects.
The buckets of protocols that have amassed a bulk of the capital that has flown into DeFi, along with their most popular platform implementations, are:
i) Lending/ Borrowing — MakerDAO, Compound, Aave, dYdX
ii) Decentralized Exchanges (DEXs) — Uniswap, Balancer, Curve, Serum
iii) Derivatives/ Synthetics — Sythnetix, dYdX, Opyn, Hegic
iv) Aggregators / Asset Management — yEarn, Harvest, Rari, 0x, 1inch, TokenSets
v) Stablecoins: USDT, USDC, DAI, AMPL
vi) Oracles: UMA, Chainlink
In this post, we will primarily focus on lending/ borrowing protocols. DEXs and other protocols (derivatives, stablecoins, asset managers, aggregators, oracles etc.) will be covered in future posts.
Growth of the DeFi Ecosystem
Global Macro Backdrop
DeFi has taken the crypto and blockchain world by storm. Billions of dollars have been locked up in lending & exchange protocols and the yields that DeFi can offer are especially attractive given the low-interest rate environment that we’re currently in. With central banks injecting massive liquidity through unprecedented levels of quantitative easing (as well as a coordinated fiscal stimulus by governments across the globe), crypto and DeFi have never been more appealing to yield-seeking investors.
Total Value Locked (TVL)
There is almost $25B of total value locked up in DeFi protocols. While this is a modest amount relative to the amount of capital flowing through the traditional financial platforms, the rapid growth in TVL is a testament to the widespread adoption of DeFi by the broader crypto community.
DeFi Users Data
There are currently almost 1 million unique addresses that have interacted with an Ethereum DeFi protocol. The number of users across DeFi protocols remained fairly consistent up through Q1 2020 and then spiked up exponentially mid-June due to the release of the Compound governance token (COMP), with Balancer (BAL), Curve (CRV) and other top platforms following suit.
Lending Protocols
Credit is the cornerstone of every financial ecosystem. It enables non-zero-sum wealth creation by allowing individuals with surplus assets to lend them to borrowers who have a productive or investment use for those assets.
The traditional financial services industry relies on counter-party trust and legally binding contracts to determine default risk and enforce creditworthiness. But, how do you translate this on to the blockchain, which can be accessed pseudonymously and lacks a centralized judicial system? Two words — over-collateralization & liquidation.
Instead of relying on their trust in borrowers, suppliers rely on overcollateralization and liquidation to ensure that they can withdraw their assets at any time. Borrowers always have to supply more value in collateral than they can borrow and suppliers can always seize that collateral through a free and open market for liquidation. These mechanics work exactly the same way regardless of the borrowers’ creditworthiness. In other words, over-collateralization and liquidation are intended to almost completely eliminate default risk.
A simple example — say the lending protocol has a 1.5x overcollateraliztion ratio and a 1.25 liquidation level. That means that if I deposit $150 worth of ETH as collateral, I can then borrow $100 worth of DAI stablecoin (or any other asset), which I will have to repay with accrued interest. If the value of my ETH collateral ever falls below $125, it will be automatically be liquidated to pay back the lenders in full ($100 + accrued interest worth of DAI).
The first lending protocol was the MakerDAO project, which in Dec 2017 launched the Dai Stablecoin System, a decentralized, unbiased, collateral-backed cryptocurrency soft-pegged to the US Dollar through unique smart contracts known as Collateralized Debt Positions (CDPs).
Following MakerDAO, a number of other lending platforms, such as Compound and Aave, came up that used similar collateralization and liquidation protocols. The rest of the DeFi ecosystem also began to take shape, with some of the early DEXs/ AMMs, insurance, and asset management platforms launching throughout the late 2018 — mid-2019 period.
Superfluid Collateral
Any crypto asset A can be lent out to earn yield through a lending protocol. In return, the lender will receive an asset that represents a claim on the underlying asset A, as well as all of the lending interest that it accrues. Let’s call the asset or token, that represents this claim cA. Now cA itself is an asset that can be borrowed, lent, traded, swapped etc. As it can always be exchanged for the underlying asset A (+ accrued interest), its value is always greater than the A, and will continue to increase steadily over time as interest accrues.
Hence, every crypto asset A, has a yield earning counterpart cA that’s wrapped in a lending protocol. It almost always makes sense to own the wrapped coin, as it is always worth more than the underlying coin and bears (almost) no additional risk. The beauty of wrapped coins is that it creates a financial universe where every single asset can, and should, be earning an efficient risk-adjusted yield.
In addition, cA itself is an asset, and so it can be used as collateral to borrow another asset, say B which can then be further lent out and so on. Hence collateral can be lent out, and that lent out collateral can replace the original collateral. And so on. Till infinity? Sure, as long as there are no transaction/ gas fees.
A great example of a protocol that leverages this beautifully is Compound. The Compound protocol aggregates the supply of each user; when a user supplies an asset, it becomes a fungible resource. Suppliers are issued cTokens that represent a claim on the underlying asset, along with the accrued interest. In this way, earning interest is as simple as holding a ERC-20 cToken, whose value relative to the underlying token constantly increases over time.
In addition, Compound allows users to frictionlessly borrow from the protocol, using cTokens as collateral, for use anywhere in the Ethereum ecosystem. Supplied collateral assets earn interest while in the protocol, but users cannot redeem or transfer collateral while it is securing an open borrowing position.
If the value of an account’s borrowing outstanding exceeds their borrowing capacity, a portion of the outstanding borrowing may be repaid in exchange for the user’s cToken collateral, at the current market price minus a liquidation discount; this incentivizes an ecosystem of arbitrageurs to quickly step in to reduce the borrower’s exposure, and eliminate the protocol’s risk.
Single-Asset Recursive Money Market Model
Let’s consider a crypto investor that holds all of their wealth in DAI. They can leverage money-market platforms, like Compound, to borrow more DAI, as long as they are sufficiently collateralized. They can continue to do this recursively to infinity, by lending out the borrowed DAI and using that as collateral to borrow more DAI and so on (ignoring transaction costs and gas fees)
The expected wealth from this strategy can be represented as:
If c = 1.5, we can simplify this infinite GP series to:
Hence, the money market protocol enables crypto traders to leverage their positions by 3x, through recursive borrowing & lending.
Summary
1) Wrapped tokens are risk-free claims on an underlying coin/ asset and are steadily increasing in value, relative to the underlying asset, due to accrued interest
2) These wrapped tokens are themselves assets that can be used as collateral on lending protocols. Hence, risk-free yield can be earned on assets locked up as collateral
3) Recursive lending and borrowing enables crypto traders and investors to obtain leverage and to generate additional yield on their assets
