Challenges in Current Lending Protocols: Platforms such as Aave and Compound, two prominent players in the DeFi lending ecosystem, utilize several basic mechanisms:
- Over-collateralization: This essentially requires borrowers to deposit an amount of assets, like ETH, which is much higher than the amount they wish to borrow, usually in the form of stablecoins.
- Fluctuating Interest Rates: These are dynamic and change according to supply and demand. As more borrowers utilize the available liquidity pool, interest rates tend to rise quickly to encourage repayment or additional deposits.
- Collateral Liquidation: If the collateral’s market value drops below a critical ratio (factoring in the borrowed amount and interest), it’s sold off, thereby clearing the user’s debt.
However, this prevailing model has an inherent flaw. When market prices tumble rapidly, a cascade of liquidations can be initiated. This not only heightens interest rates but also fosters an environment ripe for market panic. The recent fall in CRV is a case in point. The market not only panicked about CRV liquidations leading to its price crash but also worried about potential bad debts in stablecoins across lending platforms, shaking the entire DEFI sector. Borrowers, fearing these sudden market downturns, often reduce their capital efficiency by depositing significantly more than necessary, hoping to avoid liquidation. It’s tough to simultaneously satisfy capital efficiency, pool liquidity, and effective liquidation under this model.
The Innovative Solution: A No-Liquidation Lending Protocol
This new approach proposes a lending protocol with predetermined terms using ETH as the primary collateral. The beauty lies in its simplicity: borrowers define a liquidation price when initiating the loan, and as long as they repay before the set deadline, their collateral remains secure.
Mechanism Breakdown
1. Borrowers’ Perspective: They pledge ETH, procure stablecoin loans (like USDC) devoid of periodic interest, and lock in a liquidation price. The essence here is that even if the market price of ETH plummets beneath this price, the only time the collateral is in jeopardy is at the loan’s conclusion.
2. Lenders’ Perspective: They supply the requisite stablecoins for lending. As a reward, they reap the benefits of the staking returns generated by the borrowers’ collateralized ETH. If the market price of ETH does descend below the liquidation threshold, they can effectively acquire ETH at the pre-agreed liquidation price.
Central to this system is the concept of stablecoin (USDC) pools. These pools come with a clearly defined expiration date and an upper limit for the liquidation price. Borrowers interact with these pools, set their preferred liquidation price (ensuring it’s under the pool’s threshold), and then derive the quantity of USDC they’re eligible to borrow, governed by their pledged collateral.
During the loan term, Borrowers can repay early and retrieve their ETH. Lenders’ liquidity is supported by the unloaned USDC; if all USDC is lent out, they cannot withdraw funds early.
Illustrative Examples:
Let’s take two borrowers, A and B:
- Borrower A puts forth 10 ETH as collateral and earmarks 1600 USDC as his liquidation price. By these metrics, he would be entitled to a loan of 16,000 USDC. The crux is that if ETH’s price dwindles to 1600 USDC or dips even lower by the loan’s conclusion, the 10 ETH he deposited is forfeited, unless he chooses to settle the loan beforehand.
- Borrower B follows a similar procedure but with different figures: 5 ETH as collateral and 1200 USDC as the liquidation threshold. This equates to a loan of 6,000 USDC for him.
Strategic Advantages Over Conventional Systems:
This protocol allows borrowers more breathing room in setting liquidation prices, offering a buffer against hasty liquidations which platforms like Aave might trigger. Lenders, on the flip side, can potentially enjoy returns that outpace traditional deposit rates on platforms like AAVE, especially if the market price of ETH skews favorably for them.
A Comparative Deep Dive
Let’s examine a scenario where the market price of ETH is 2000 USDC.
Under the New Protocol:
- When a borrower secures 1 ETH, and opts for liquidation price at 1600 USDC, 1200 USDC, or 800 USDC
- He is able to loan out amounts of 1600 USDC, 1200 USDC, or 800 USDC respectively
In Contrast, Using AAVE:
- Securing 1 ETH as collateral and borrowing amounts like 1600 USDC, 1200 USDC, or 800 USDC
- The system would automatically assign ETH liquidation price at 1927 USDC, 1445 USDC, and 963 USDC respectively. These points are markedly elevated when compared to the liquidation price under the new protocol, potentially putting the borrower at a greater risk.
Evaluating Return Rates:
Let’s consider Lido’s stETH offering an APY of 4.2%. If we then factor in the fund pool utilization at 70% and juxtapose this with AAVE’s USDC deposit rate at 2.1%:
- Lenders operating under the new protocol, with the aforementioned liquidation points (1600 USDC, 1200 USDC, and 800 USDC), can anticipate actual returns of 4.31%, 5.53%, and 7.98% respectively. It’s evident that these returns are more generous than what’s achievable via AAVE’s deposit rate.
In summary, this new protocol offers borrowers a more flexible, and arguably, safer environment while promising lenders more attractive returns compared to existing platforms like AAVE.
Future Enhancement Considerations:
A potential enhancement to lenders might be to incorporate real-time liquidations at the previously agreed-upon prices during the active loan period. This maneuver would potentially allow lenders to snag ETH at enticing prices, but would demand borrowers to be on their toes, consistently monitoring the fluctuating price of ETH.
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Summary
The prevailing lending models in the DeFi sector, represented by platforms like Aave and Compound, have inherent challenges tied to market volatility and the fear of unexpected liquidations. The “No-Liquidation Lending Protocol” offers a refreshingly simple yet effective alternative. Here, borrowers deposit ETH, define their own liquidation price, and can reclaim their collateral as long as they settle their loans before the due date. This model provides both borrowers and lenders with increased flexibility and potentially higher returns, respectively.
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SCapital, a visionary crypto-native fund, is championing novel strategies in the DeFi landscape. Beyond mere investment, we actively partake in governance and advisory roles, ensuring continuous value growth.
