Yield Protocol, which introduces fixed-rate lending to DeFi, just released a beta version on Ethereum. What new ways will it bring?
This article was published in June of this year. Reading this article again can help you better understand the operating mechanism and application potential of Yield Protocol.
Written by: LeftOfCenter
Dan Robinson, an analyst at the well-known crypto investment fund Paradigm, published a paper last summer and proposed a protocol framework called “The Yield”, based on which a cryptocurrency version of zero coupon bonds can be issued on the Ethereum blockchain— — “YToken”.
“YToken” can introduce a “fixed-term, fixed-rate loan” tool to Ethereum to meet the risk preferences of different borrowers -you know, as the fastest growing track in the decentralized finance (DeFi) boom, Up to now, the loan products provided by various lending platforms cannot fix the term and interest rate. They are all floating interest rates, and interest rates have changed greatly . However, the rise of DeFi and the diversified needs of the financial market have made interest rate swaps a new demand. For this reason, a series of related new products have emerged. For example, the AMM- based on- chain interest rate swap agreement Rho can provide fixed interest for Compound, swaprate.finance launched by Opium, can change Compound’s interest rate swap to a fixed interest rate, and Dharma’s second-generation product also made an interest rate swap based on the Compound agreement, that is, the compound’s floating interest rate was changed to a fixed interest rate. In addition, as a new DeFi primitive, “yToken” can also construct interest rate curves for specific tokens, providing interest rate predictors for DeFi platforms such as MakerDAO, dYdX, Compound, and even speculation (long or short) to earn income .
Just recently, a team named Yield has begun to put the white paper into practice. The team is currently developing the first product “yDAI” based on the “The Yield” protocol framework, and the team’s CEO Allan Niemerg has proposed a new idea based on the original white paper: he is based on the original cash and physical settlement solution. In the above, a new synthetic asset settlement scheme is proposed, which can seamlessly solve the settlement experience of synthetic assets without the need for oracles and auctions .
At the same time, the Yield team has also been recognized by the crypto investment fund Paradigm Capital and obtained the latter’s seed round of financing . The project will also become the first incubation project of the crypto investment fund Paradigm Capital.
What is the potential of yToken, which claims to be a key piece of Ethereum LEGO components? What possibilities will it bring to the DeFi ecosystem ? How to short the underlying assets in combination with the automatic market making mechanism without liquidation risk? And, what is its basic operating principle? If you want to know these answers, listen to Chainwen’s interpretation of the white paper.
What exactly is yToken?
Simply put, yToken is a cryptocurrency version of “zero coupon bond” . What about zero coupon bonds?
In traditional finance, a zero-coupon bond is a debt instrument that can be sold at a discounted price lower than the face value and can only be redeemed after maturity. This means that if you redeem it on the maturity date, you can get a higher value than the purchase price and thus get a profit. In zero-coupon bonds, the buyer lends the target asset, which is equivalent to lending legal currency to obtain interest for a period of borrowing. The interest is the difference between the par value and the actual purchase price.
In layman’s terms, the old Wang next door gave you a blank note with a face value of 100 yuan, and then you only borrowed 90 yuan in cash to him. After the white bar expires, Lao Wang used 100 yuan to redeem the white bar he gave you. At this time, you can get a 10 yuan spread when it expires, which is interest.
Zero coupon bonds can provide stable returns to lenders and meet the needs of investors who prefer stable returns.
In Ethereum’s decentralized finance, such financial tools are also needed. As we all know, MakerDAO, the largest stablecoin protocol on Ethereum, allows users to deposit stablecoins as collateral, providing a series of potential use cases for traders and investors. But for MakerDAO lenders, a floating annual interest rate must be paid. The data shows that MakerDAO’s interest rate fluctuates greatly. MakerDAO’s stability fee once reached a maximum of 20.5% and a minimum of 0.5%.
In the DeFi ecosystem, a method that can achieve loans at a fixed interest rate is needed to meet the needs of borrowers to achieve loans with a fixed interest rate, so that they can borrow more safely and make reasonable predictions about future investment costs. This is one of the functions of the protocol that Yield is developing-the issuance of tokenized zero coupon bonds.
yToken is a zero-coupon bond minting primitive based on the Ethereum blockchain, which is equivalent to a synthetic financial asset with a maturity date. As an ERC20 standard token, it is essentially a zero-coupon bond based on Ethereum. Unlike traditional finance, a yToken can be customized to be linked to any target asset on Ethereum, such as the zero coupon bond token yDai corresponding to Dai, or the zero coupon bond token yETH corresponding to ETH.
Taking yDAI as an example, a yToken may represent: Based on ETH collateral, the holder (purchaser) can redeem the equity of 1 DAI on a specific maturity date. For buyers, through Yield, the floating interest rate of DAI can be exchanged for a fixed interest rate within a certain period of time.
For the mint (seller) , yDAI is created by depositing collateral (such as ETH), and the target asset DAI is obtained after selling. This process is equivalent to borrowing the target asset DAI . If the price of the target asset DAI rises, it will cause the value of the debt to be repaid to rise, so the value of the collateralized assets of the vault will fall. If the situation is the opposite, that is, the price of DAI falls, or the price of the mortgage asset ETH rises, the mint can sell DAI to short it or make long arbitrage on the mortgage asset ETH.
If the caster expects that the price of the target asset DAI will fall for a period of time in the future, then they can make a profit by selling DAI short. If the mint is optimistic that the price of the mortgage asset ETH will rise in the future, then it can also increase its exposure by increasing leverage in this way: the trader can sell yDAI and then buy more mortgage assets to generate yDAI, repeat the operation several times to obtain Several times the leverage of mortgage assets. This is equivalent to increasing the long exposure of mortgage assets (relatively increasing the short exposure of the target asset), and of course it also increases the liquidation risk.
How to mint yToken?
After understanding the basic principles of yToken, let us see how to mint yToken.
Take the first application of yDAI as an example. The token is used as an equity certificate, allowing borrowers to pledge ETH to issue yDAI with different redemption periods. The redemption period can be set to one week, one month or one year.
Any yToken of a specific period needs to deploy a specific smart contract at the beginning. Taking yDAI as an example, a yDAI smart contract must be deployed first, which is mainly based on 4 parameters : target asset, mortgage asset, expiry date, and mortgage rate. For example, you can set a yDAI like this: ETH mortgage support, expiry date at 11:59 pm on December 31, 2020, mortgage rate 150%, and target asset as DAI.
After the contract is deployed, anyone can deposit the mortgage asset ETH into the vault of the contract ( similar to the vault of MakerDAO ), minting yDAI, every new yDAI minted will increase the debt of the vault, and destroying yDAI will reduce the debt . The debt of a particular vault must not exceed the total amount of its collateral plus margin, otherwise it will be liquidated. After the contract expires, the yDAI can be used to exchange assets equal to the face value from the contract. The yDAI generated by different vaults in a contract is homogeneous, so it can be sold and traded.
Cast and sell yDAI people equivalent to the borrower: as a coin, they credited cast yDAI ETH collateral, and then sell, borrow target assets DAI.
The buyer is the lender of the target asset DAI : by purchasing yDAI, the DAI is loaned.
In the above case, a yDAI with a face value of 1 may be available for only 0.97 DAI, and the holder, that is, the lender, can exchange it into a face value of 1DAI on the expiry date and obtain a fixed income of 0.03DAI.
Understand the interest rate predictor and interest rate curve on the chain
YTokens with the same target asset but different maturities are homogenized tokens, which means that they can be traded freely in the market, and their prices are free to float based on supply and demand. Generally speaking, they will be traded at a discount to their face value before expiration. Therefore, based on the market transaction price, the annual interest rate of different maturities can be inferred.
Combining the discount price and expiry time can infer the annualized interest rate that will be obtained by purchasing yToken and holding it to maturity. The deduction method is similar to the calculation of interest rate based on the price of zero coupon bonds, which is based on the following formula:
Among them, Y represents the annualized rate of return of yToken, F is the face value, P is the present value, and T is the number of years to maturity:
If a yToken with a face value of US$1 expires after March and the current price is US$0.97, the annual interest rate can be calculated according to the above formula to be about 13%.
This interest rate can be used as an indicator of the spot interest rate of the target asset to provide a reference for lending agreement platforms such as Maker, Compound and dYdX to determine the payment interest rate in a certain period . If the price can be determined on the chain, it can also be used to settle on-chain interest rate derivatives (such as swaps).
In addition, these data can also reflect market expectations , that is, market expectations of how interest rates will change in the short term. This is the term structure of interest rates. In actual cases, the structure will also be affected by other factors, including liquidity or the perceived vulnerability of smart contracts.
For different maturity dates of the same target asset, the implied return of the yToken can be calculated to create a yield curve :
These yield curves can be used as a reference for the governance of Maker, Compound and dYdX’s lending agreement platforms, and at the same time, provide traders and analysts with necessary information for investment operations and economic decisions.
New ways to play interest rate arbitrage
The above interest rate curve can reflect the market’s average expectations for the target asset interest rate in a specific time period, but if they do not agree with these expectations, market participants can use this to make money-this is another use case of yToken: the future interest rate To speculate .
Take yDAI and Chai (an ERC-20 token that is encapsulated in Maker’s deposit contract and can earn interest income by storing Dai) as an example, users can use Chai as collateral to mint yDAI. Since Chai is a smart contract that encapsulates DAI in a DSR floating rate, holding Chai means having the right to earn DSR. Therefore, for the borrower, the DSR floating interest rate of holding CHAI can be obtained at this time, and the fixed interest of yDAI needs to be paid at the same time.
If a trader believes that Chai’s floating interest rate will be higher than the fixed interest rate paid to yDAI for a period of time in the future , and is confident in his prediction, he can sell yDAI multiple times to obtain Chai plus leverage to do more, thereby conducting speculative arbitrage.
On the contrary, if the trader believes that the fixed interest rate of yDAI will be higher than the floating interest rate of Chai for a period of time in the future, then yDAI can be mortgaged to cast yCHAI for speculative arbitrage. At this time, for the borrower (caster), the fixed interest of the collateral yDAI can be obtained, and the floating interest of Chai must be paid to the yCHAI buyer.
Uniswap automatic market making mechanism can provide leveraged liquidity for yToken
If you want to construct an interest rate curve or even an interest rate predictor through market transactions, there is a condition that yToken must be liquid. Thanks to the composability of DeFi, such a Uniswap automatic market making platform can be integrated to introduce a liquidity pool for yToken.
The newly released Uniswap V2 version supports any ERC20 and ERC20 trading pair, which means that Uniswap can provide liquidity for ERC20 and its underlying assets (if it is also ERC20 standard), such as yDAI/DAI.
For market makers, they earn transaction fees by contributing liquidity to specific yToken trading pairs, and because the prices of these assets at maturity can be roughly predicted, the arbitrage risk due to volatility will be much smaller. Taking yDAI as an example, a certain amount of DAI will be redeemed upon expiry of the token guarantee, which makes the future price of yDAI/DAI liquid tokens predictable.
Furthermore, the DAI/yDAI fund pool can be used for collateral to mint yDAI. In other words, traders can inject yDAI and DAI trading pairs into the Uniswap fund pool to contribute liquidity. Based on the reserves of the fund pool as collateral, repeatedly cast yDAI multiple times, and recycle leverage to make more liquidity reserves. , To further increase the scale of assets. Since the risk coefficient of the DAI/yDAI fund pool is small, the liquidation risk is extremely small.
In addition, there are more configurable automatic market makers that can be expanded, from only supporting trading yToken, to minting/destroying, or trading yToken with different expiration dates for arbitrage.
Understand the settlement mechanism
For the zero-coupon token yToken, one of the most important processes is the settlement mechanism , that is, how to determine the settlement at a uniform price after expiration.
In the yToken system, different target assets have different settlement mechanisms. There are four settlement mechanisms, namely cash settlement, physical settlement, and newly-added synthetic asset settlement . In addition, there is a general-purpose settlement mechanism derived from the synthetic asset settlement mechanism, which is suitable for the settlement of asset pairs supported by various DeFi lending platforms .
1. Cash settlement <br/>Cash settlement, to be more accurate, is based on collateral assets for settlement. As a settlement mechanism, the premise of this mechanism is that there is an accurate price feed that uses the collateral assets to value the target asset Oracle .
In this mechanism, yToken holders can redeem mortgage assets of equivalent par value at maturity . Once it expires, anyone can call the function of the token contract to trigger settlement, and then call the corresponding oracle to find the current price of the target asset denominated by the mortgage asset and store it as the settlement price. After that, anyone can use the settlement price to exchange yToken for a certain amount of equivalent collateral. In addition, after maturity, any vault owner can withdraw the mortgage assets after the debts need to be paid.
The advantage of this settlement mechanism is that it can support any target asset (not limited to ERC20) . The disadvantage is that a price-accurate oracle is required for settlement.
2. Physical settlement through auction <br/>If the target asset is a token in the ERC20 format , yToken can be settled using physical objects , which means that yToken holders will settle with the target asset .
This settlement mechanism is mainly realized through auctions. For each vault with outstanding debt, the mortgage assets can be sold through a Dutch reverse auction to repay the debt.
Assume that an expired vault has 1 ETH of collateral and needs to repay 100 yDAI of debt. The agreement can start an initial quotation with 0.01 ETH/100 DAI, and then gradually increase the price until someone accepts it. The token DAI obtained in the auction will be distributed to yToken holders with redemption needs, and the remaining collateral will be returned to the vault creator.
The advantage of this mechanism over cash settlement is that, assuming the auction is successful, each yToken will be fully supported by the target asset instead of a certain amount of mortgage assets. This means that without any action, yToken holders can maintain the same exposure to the target asset and can exchange it at any time.
However, this mechanism does not allow the borrower to maintain its debt position after maturity , leaving only the remaining collateral after the auction.
3. Settlement of synthetic assets
The synthetic asset settlement plan is the new content added in this revised version of the white paper . This plan can ensure that the settlement experience of synthetic assets is seamlessly resolved without the need for oracles and auctions.
Specifically, when the underlying asset of yToken is a mortgage synthetic asset, such as DAI, when it expires, the target synthetic asset issuance mechanism will be used for settlement.
Specifically, when the yDAI token expires, the agreement will send the ETH collateral in the Yield vault to MakerDAO vault, and re-mint DAI based on the collateral, thereby satisfying the redemption target asset DAI of the yDAI holder Demand.
At this time, yDAI holders can redeem the loaned asset DAI, and the agreement will borrow DAI from Maker and pay it to the exchanger. The borrower can still maintain its debt position, but from this time onwards, it has changed from paying a fixed interest rate to paying a floating interest rate, which will be used by the agreement to pay Maker a stability fee for borrowing DAI. Until the borrower repays DAI and closes the debt warehouse, the agreement also pays off Maker’s debt and the borrower takes back the collateral.
If the holder of yDAI chooses to continue to hold and not pay, then the agreement starts to pay interest to holders of yDAI with floating interest. In this case, after the expiry of the yDAI backed by ETH, the agreement will start to charge the borrower the Maker stability fee in ETH, while paying DSR to the yDAI holder.
From another perspective, the mechanism is that after maturity, the user’s fixed-rate yToken position is transferred to floating-rate debt .
The advantage of this mechanism is that both borrowers and lenders can continue to maintain their previous positions after maturity. The difference is that they are now paying floating interest rates instead of fixed interest rates.
4. Settlement mechanism based on lending platform <br/>Further, the above settlement mechanism for synthetic asset platforms such as Maker can be generalized to support asset pairs that provide floating-rate lending on various DeFi lending platforms (such as Compound) Settlement.
For example, after a certain yToken expires, the agreement will be settled based on Compound. During settlement, the yToken agreement issues collateral to Compound to borrow target assets for settlement. After that, the borrower pays loan interest to Compound until the debt is paid off and the debt warehouse is closed, while the lender can get the loan interest paid by Compound until the yToken is converted into the corresponding ctoken.
As a result, yToken can be settled by receiving other lending agreements, usually such agreements allow synthetic exposure of target assets based on mortgage assets (whether through casting or borrowing). As long as the exposure closely tracks the market price of the target asset after expiration, the yToken price before expiration can reflect the true yield curve of the target asset/collateralized asset pair.
source:
http://research.paradigm.xyz/Yield.pdf
https://twitter.com/danrobinson/status/1169725595082620929
