Protocol to Protocol Lending
For close to a year now, our team has been laser-focused on shipping software and less-so on communicating why. We spend a lot of time studying history, analyzing trends, and investigating top businesses in finance to create simple yet ambitious strategies that solve some of DeFi’s biggest challenges. In this article, I would like to distill some of the ideas that drive our mission to fix DeFi business models through protocol-to-protocol lending.
Fixing problems here and now
When designing Ethos, the DeFi industry was in the throes of a painful bear market. Demand for leverage was low and interest rates were even lower, and while we watched households take on more debt in the trad-fi world our team wondered whether DeFi lending had the product market fit we thought it did in 2021.
Looking deeper, we found that even in 2021, DeFi lending was vastly under-utilized. Major lenders were sitting on hoards of crypto-assets without anywhere near enough demand to fully utilize them. It seemed that more users were interested in farming tokens than they were in using these protocols as intended.
While many teams were describing fantastical worlds wherein millions of new users would ride in like the Rohirrim at Helm’s Deep to re-cement DeFi’s product-market fit, our team was wondering how we could make DeFi work right now, and how we could better service each of the users marching through Crypto Winter with us.
So where do we find demand?
A little while before the DeFi crash of 2022, I spoke heavily about lending protocols’ incessant drive for more counterparty risk as a means of gaining market share. I likened stablecoins during this era to mortgage-backed securities, as popular protocols repackaged sub-par assets into seemingly premium collateral, shifting huge amounts of hidden risk onto users. The results, I believe, have spoken for themselves.
Our team has chosen to address these issues from an infrastructure level first, through smart-contract innovation. To us, this meant overhauling the architecture our teams build applications on. We wanted Ethos to address a larger market without taking on significantly larger risks.
So we looked to where demand was insatiable — other protocols.
The Reaper.Farm team has been serving protocols’ demand for liquidity for over 2 years now, and sees a big opportunity in DeFi lending to service this market with un-utilized capital. In this way, protocols like Ethos are able to address a much wider market without exposing themselves to hard-to-quantify counterparty risks that come with accepting sub-par collateral. Furthermore, these risks are much easier to manage, as smart contract behavior is programmable and outcomes can be predicted more reliably.
The result is a protocol that acts not only as a lending service provider, but as a programmatic capital allocator on behalf of its users, capable of absorbing yield and distributing it back to lenders and borrowers.
Identifying and Managing Risks
The most obvious drawback to a protocol-to-protocol lending system is the increased risks associated with external dependencies. While any new token introduced to a system may introduce similar dependency risks, interacting directly with external protocols carries a different set of challenges that our team has been managing for nearly 3 years.
There are two main types of risks when targeting protocols to lend to: Downside Risks and Long-Tail Risks.
Downside Risks are often exogenous, and include risks associated with one-off events that may wipe out a portion of the lending pool’s principal. These risks can turn otherwise ‘only-up’ strategies into lossy ones, and must be accounted for within any risk management strategy. Because of our team’s risk-off approach to yield generation, these measures are often preventative, with initial periods of due diligence and regular audits of security and risk parameters.
In delta-neutral strategies, downside risks can include smart contract exploits, dependency mis-management, and op-sec failure. These are events which can wipe out months of work in an instant, and must be avoided at all costs. What this means is that only battle-tested, well-audited, and well-understood protocols with trustworthy teams can be considered for integration.
Long-Tail risks are ones that build over time, and are often endogenous. We see these risks evolve from innocuous mis-configuration or lack of oversight into potentially existential threats. We find long-tail risks surface in poorly configured loan-to-value ratios, wherein lending platforms issue loans that would be impossible to liquidate at scale.
Mitigating these threats is a much longer and more complex process than introducing them, so the answer to long-tail risk is often moving slow and triple-checking work. Our team thinks hard about how system parameters will scale with market size and the amount of accessible liquidity, and analysts are always looking for these risks before they metastasize.
A New DeFi Business Model
Protocol-to-protocol lending isn’t unique: firms have been lending to each other since the dawn of finance. Where TradFi often fails, however, is ensuring that this lending is transparent, auditable, and that risks are sufficiently minimized. DeFi allows us to permissionlessly enter and exit these lending agreements, and through the power of composability, their associated risks can be managed block-by-block.