An introduction to Notional Finance, a fixed-rate lending protocol
Notional Finance is one of the first DeFi lending protocols on the Ethereum blockchain to offer fixed-rate services. This novel approach empowers cryptocurrency traders to deposit and borrow digital assets at predictable interest rates, immune to the turbulence of market fluctuations.
The Fundamental Mechanism
At the core of Notional Finance’s innovation lies a specialized token known as fCash, serving as the linchpin of its fixed-rate lending protocol. This protocol enables the lending and borrowing of crypto assets with fixed interest rates and predetermined timeframes. It achieves this by employing transferable fCash tokens, each representing claims on future cash flows at specific points in time. Each fCash token is distinguished by two pivotal elements: the associated cryptocurrency and the maturity date. It’s essential to note that fCash tokens always come in pairs, striking a balance between assets and liabilities within the system.
Quote Currency vs. Settlement Currency
Notional Finance V2 introduces an intriguing distinction between the quote currency and the settlement currency for fCash tokens. While fCash is quoted in base tokens like DAI or USDC, its settlements are conducted in cTokens, such as cDAI or cUSDC — the interest-bearing tokens provided by Compound. This innovative design optimizes capital efficiency by allowing liquidity providers to deposit the base currency as cTokens, bolstering their returns. They can earn floating interest on their cTokens alongside interest from capital lent out on Notional and liquidity fees from the Notional liquidity pool.
From the perspective of depositors, when a loan matures, their fCash transitions seamlessly into Compound’s cTokens, thereby enabling them to earn variable interest. In essence, this transition ensures that even fixed-rate loans, upon maturity, convert into variable cToken deposit rates.
The Settlement Mechanism
When cash assets reach their maturity date, Notional determines the quantity of cTokens equivalent to the face value of the cash assets and converts the user’s cash into that precise quantity of cTokens.
The settlement rate, a critical component of this process, is defined as the cDAI/DAI rate at maturity. Importantly, this rate remains unknown until the point of maturity, and remains constant after maturity.
The following is an example of how the value of 100 fDAI with a maturity date of December 1, 2021, changes over time based on changes in the cDAI/DAI rate.
It’s important to note that “cDAI to Redeem” is set to a specific amount so that the DAI value of “cDAI to Redeem” at maturity equals the face value of fCash. Even if the DAI value of “cDAI to Redeem” increases, it remains constant after maturity. This reflects the passive accumulation of cToken deposit rate earnings by Notional’s cash balance.
Liquidity Pool and nToken
It’s essential to emphasize that because depositors and borrowers are unlikely to engage in deposit and borrowing actions at the same time, the counterparty for both depositors and borrowers is the Liquidity Pool. These liquidity providers ensure that there is always cash and fCash available for depositors or borrowers at any given time and charge transaction fees as compensation. Liquidity Pools are established because without LPs injecting funds into the pool, there would be no fixed-rate borrowing and lending activity.
Notional offers fCash trading within its built-in AMM liquidity pool. The Notional liquidity pool holds fCash and its settlement currencies (e.g., cDai and fDai together).
Liquidity providers deposit cTokens into the Notional liquidity pool and receive nTokens in return. These ERC-20 nTokens represent the liquidity provider’s share in a specific currency’s total liquidity and can be redeemed at any time. nTokens allow LPs to passively provide liquidity to all active liquidity pools without any direct interaction with the underlying liquidity pool. The system automatically allocates liquidity to various pools, with the allocation ratio determined by community governance to maximize capital utilization.
Part of the deposited cTokens is used to purchase fCash. Consequently, the liquidity pool comprises cTokens and fCash, and the blended interest rate earnings on nTokens fall between fCash and Compound’s deposit interest rates.
While the returns for liquidity providers are lower than fCash interest rates, it’s important to note that LPs’ primary purpose is not to secure fixed returns. Therefore, the protocol employs several ways to reward liquidity providers, which include transaction fees generated from each deposit and loan, fCash interest, base currency market interest as passive depositors in Compound, and rewards from the community governance token, NOTE. The first three sources of rewards are incorporated into the “variable rate” APY. The variable APY typically remains around 0.5%, but extreme cases can result in negative values. For example, when there’s a lack of borrowers (a surplus of depositors), LPs effectively become borrowers and need to pay interest due on maturity, causing a negative variable APY. Conversely, when there’s a shortage of depositors (a surplus of borrowers), LPs become depositors and receive interest on maturity, thus increasing the variable APY.
Let’s provide an example to illustrate this:
Initial Status
Suppose that in March 2022, the liquidity pool is in its initial state. For simplicity, assume that each nToken represents claims to 1 cToken and 1 fCash. Currently, lending and borrowing activities remain in balance, and the fCash net cash position is zero.
Scenario 1
Consider the first user as a borrower who borrows 100 cTokens at the maturity date of March 2022, in exchange for 105 fCash. At this point, the liquidity pool’s cToken claim decreases to 100, while the fCash claim increases to 305. Therefore, nTokens now have a net cash position of +105 on the March 2022 maturity date. In other words, nTokens (liquidity providers) are now net depositors for this term and will receive interest at maturity.
Scenario 2
The second user acts as a depositor in the same term by depositing 200 cTokens in exchange for purchasing 208 fCash. This operation causes the liquidity pool’s cToken claim to increase to 300, and the fCash claim decreases to 97. Now, nTokens have a net cash position of -103 on the March 2022 maturity date. In other words, nTokens (liquidity providers) are now net borrowers for this term. If the negative fCash generated interest due to maturity is greater than the transaction fees plus Compound’s earnings, a negative variable APY will occur.
nTokens’ net cash position reflects the collective activity of all end-users in Notional. When nTokens have a significant net cash position, it implies that the activity of end-users has tilted in one direction. A substantial net cash position also affects the slippage incurred when users redeem their nTokens.
However, nTokens also have a unique feature that provides high capital efficiency for liquidity providers. After liquidity providers receive nTokens, they can use them as collateral to borrow, effectively leveraging nTokens.
Fixed-Rate Deposit and Borrow Mechanism
Depositors lock in a fixed interest rate by purchasing discounted fCash. fCash represents their right to receive a specific amount of the underlying currency at maturity. Borrowers create fCash by over-collateralizing their assets, sell fCash to obtain the underlying currency, and take on an obligation to repay it at a specific future time.
Fixed-Rate Deposit: Depositors pay DAI into the liquidity pool, which is automatically converted to cDAI in the Compound, and then use cDAI to purchase discounted zero-coupon bonds (fDai) in Notional. The difference between the DAI paid by depositors and the amount of the underlying currency they receive at maturity represents the fixed deposit interest they earn.
Consider a depositor aiming to make a fixed-rate deposit of 100 DAI on Notional for one year. The depositor converts their 100 DAI into cDAI and then deposits cDAI into the Notional liquidity pool to purchase 105 fDAI. When the loan matures on December 1, 2021, the depositor can redeem their 105 fDAI for cDAI and then convert cDAI into 105 DAI.
Fixed-Rate Borrowing: Borrowers create a certain amount of fDai by over-collateralizing ETH. The system converts this fDai into cDai and, in the end, takes it back to obtain DAI, thereby achieving fixed-rate borrowing. Borrowers receive DAI at the start of the transaction and are required to repay the difference between the DAI received and the fDai created at maturity. This difference is the fixed borrowing interest payable by borrowers.
In the example below, a borrower initially deposits ETH in Notional.
Later, on their chosen maturity date of December 1, 2021, creates a pair of fCash tokens.
The borrower can now sell the positive fCash tokens to the liquidity pool in exchange for the underlying currency.
By collateralizing assets, borrowers obtain a loan along with the obligation to repay it (collateral cannot be retrieved until the loan is repaid). The difference between the repayment amount and the borrowed amount is the fixed interest payable by borrowers.
Liquidation
When the price of the collateral changes, the borrower’s collateral ratio also changes. If the collateral ratio falls below the minimum collateral ratio for borrowing, the borrower’s collateral is subjected to system liquidation. During the liquidation, liquidators purchase a portion of an account’s collateral at a discount based on the on-chain oracle price and repay a portion of the debt from the account being liquidated.
Roll Over
If borrowers neither experience liquidation within the term nor repay the protocol’s debt by the maturity date, they will be automatically rolled over to a third party at a penalty interest rate. The current penalty rate is set at 250 basis points (2.5%). For example, if the previous borrowing interest rate was 6%, the new rate would be 8.5% until the borrower repays the debt. Borrowers also have the option to roll over the debt to a future term at the current term’s prevailing rate. This means that borrowers can choose to defer debt repayment, roll the debt into the nearest maturity date, and settle the debt on the next maturity date.
Notional AMM
fCash introduced by Notional Finance is essentially zero-coupon bonds, and zero-coupon bonds have a significant characteristic: their value changes over time.
Price of Zero Coupon Bond = Maturity Value / (1 + r)^n
As seen in the above formula, even though the interest rate remains constant throughout the period, the price of zero-coupon bonds will change over time. The closer it gets to the maturity date, the closer the bond’s price will be to its face value, and eventually the two prices will converge. From another perspective, if we consider Uniswap’s x×y=k as the AMM curve, without any transactions happening during a specific period, the state of the pool remains unchanged, and the price of zero-coupon bonds remains constant. However, as it approaches the maturity date, the APY exhibits exponential growth, attracting arbitrage opportunities and causing liquidity providers to incur impermanent losses.
Hence, AMMs that do not account for time are no longer effective in the secondary market for pricing fCash. There’s a need for a curve that automatically adjusts quotations, making the price of zero-coupon bonds more sensitive to time and interest rate changes from the start, allowing it to adapt to market conditions. As the maturity date approaches, the market price of fCash should continuously converge to its face value.
The Notional AMM consists of three variables: Scalar, Anchor, and Liquidity fee.
Scalar and Anchor allow the slope and position of the curve in the xy plane to change. The Scalar parameter represents the sensitivity of price to demand, and as the maturity date approaches, the curve will become smoother, concentrating liquidity around the price anchored by the Anchor parameter. Increasing the Scalar value makes the curve flatter, while decreasing it makes the curve steeper. This means that a larger Scalar value results in a less sensitive curve and lower slippage in a given transaction. Conversely, a smaller Scalar value leads to a more sensitive curve and more slippage in a given transaction. Changing the Anchor allows the curve to move up and down on the XY plane. The Anchor’s design is intended to keep the rate constant when the price is stable, preventing time from affecting the interest rate.
The problem of static sensitivity is not only related to the liquidity curve but also to the liquidity fee. The same reasoning applies here: the constant fee in terms of the exchange rate increases the punitive effect on end-users exponentially as fCash tokens approach the maturity date. To address this issue, the protocol transforms Scalar and liquidity fees into functions of the maturity date, with each parameter being a root value. Making Scalar a function of the maturity date means that the shape of the liquidity curve changes as we approach the maturity date. This design ensures that the scale of fees linearly decreases to zero over time, reducing the fee’s impact on the annualized rate.
Therefore, by combining these three parameters, we arrive at the pricing formula for the Notional AMM:
Notional’s Liquidity
Since its launch in late 2022, Notional Finance has encountered fluctuations in its liquidity Total Value Locked (TVL), with a stabilizing trend around $24 million as of October 2023. The platform’s user base has grown gradually, with liquidity providers relying on NOTE incentives to maintain liquidity.
The fixed-rate lending and borrowing has a significant market share in traditional finance. However, In Defi, variable -rate lending and borrowing protocol like AAVE and Compound dominate the market. The bear market and lack of institutional participation are some reasons why Notional is not performing well, as fixed-rate lending and borrowing is ofter required by large fund volumes to hedge the unpredictable interest cost risk. Increasing capital efficiency is crucial to Notional to acquire large liquidity and provide competitive interest rate to both lenders and borrowers.
In previous version of Notional, the underlying assets such as USDC or Dai were actually deposited into Compound, allowing LPs to earn Compound’s floating interest in addition. However, due to a problem with Compound’s cTokens, the current version has removed this connection and unused funds in the protocol remain in the liquidity pool without generating any yield for LPs. This significantly reduces the return of LPs, especially during times when the stablecoins have high returns, leads to liquidity draining. What makes the situation worse, is that low liquidity in the pool can result in a significant increase in borrowing rates even when only a small portion of the fund is borrowed, making it less attractive to borrower. Fewer borrower mean lower returns for both lenders the LPs, creating a downward spiral. In order to retain liquidity, the protocol must incentivise LPs by issuing more NOTE token, which acts as a drag on the token price.
The introduction of Notional V3, which supports variable-rate lending and borrowing, partially addresses the capital efficiency issue by offering variable-rate interest to lenders / LPs. With both fixed-rate and variable-rate modes available, more complex financial products like IRS (Interest Rate Swap), can be built upon Notional protocol. However, new question arises as to whether building a native variable-rate protocol is a better choice than utilizing an existing one. Unless the interest mechanism offers clear benefits to both lenders and borrowers compare to existing players, a new variable-rate lending/borrowing protocol may struggle to gain market share and be adopted.
Notional is on the way at the correct direction. We believe in the future of Notional Finance.
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