What possibilities will the encrypted version of zero-coupon bond yToken incubated by Paradigm bring to DeFi?
Editor's Note: This article comes fromChain News ChainNews (ID: chainnewscom), Written by LeftOfCenter, published with permission.
Editor's Note: This article comes from
Chain News ChainNews (ID: chainnewscom)
Chain News ChainNews (ID: chainnewscom)
, Written by LeftOfCenter, published with permission.
"yToken" can introduce a "fixed-term, fixed-rate loan" tool to Ethereum to meet the risk preference needs of different borrowers-you know, as the fastest-growing track in the decentralized finance (DeFi) boom, Up to now, the lending products provided by each lending platform cannot have a fixed term and interest rate. They are all floating interest rates, and the interest rates vary 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, such as the AMM-based on-chain interest rate swap agreement Rho, which can provide fixed interest rates for Compound, swaprate.finance launched by Opium, which can swap Compound interest rates for fixed rates, and Dharma's second-generation product also makes an interest rate swap based on the Compound protocol, which changes the floating interest rate of Compound into a fixed interest rate. In addition, as a brand-new DeFi primitive, "yToken" can also construct the interest rate curve of a specific token, provide interest rate oracles for DeFi platforms such as MakerDAO, dYdX, Compound, and even speculate (long or short) to earn income .
Just recently, a team called Yield has started to put this white paper into practice. At present, the team is developing the first product "yDAI" based on the "The Yield" protocol framework, and the team's CEO Allan Niemerg proposed a new idea based on the original white paper: he based on the original cash and physical settlement scheme. On , a new synthetic asset settlement scheme is proposed, which can seamlessly solve the settlement experience of synthetic assets without the need for oracle machines and auctions.
At the same time, the Yield team has also been recognized by the encryption investment fund Paradigm Capital, and obtained the latter's seed round financing. This project will also become the first incubation project of the encryption 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 asset in combination with the automatic market-making mechanism without the risk of liquidation? And, what is the basic principle of its operation? To know these answers, listen to Lianwen's interpretation of the white paper.
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What exactly are yTokens?
Simply put, yToken is a cryptocurrency version of a "zero-coupon bond." So what are zero-coupon bonds?
In traditional finance, a zero-coupon bond is a debt instrument that can be sold at a discount to its face value and can only be redeemed at maturity. This means that if you redeem on the maturity date, you will get a higher value than the purchase price, thus making a profit. In zero-coupon bonds, the buyer lends the target asset, which is equivalent to lending legal currency, and earns interest for a period of borrowing. The interest is the difference between the face value and the actual purchase price.
In layman's terms, Lao Wang next door gave you a white note with a face value of 100 yuan, and then you only lent Lao Wang 90 yuan in cash. After the IOU expires, Pharaoh redeems the IOU he gave you with 100 yuan. At this time, you can get a difference of 10 yuan when it expires, which is the interest.
Zero-coupon bonds can provide lenders with stable returns, meeting the needs of investors who prefer stable returns.
In the decentralized finance of Ethereum, such financial tools are also needed. MakerDAO, the largest stablecoin protocol on Ethereum, is known to allow users to deposit and lend stablecoins against collateral, offering traders and investors a range of potential use cases. But for MakerDAO lenders, a floating annual interest rate must be paid. The data shows that MakerDAO’s interest rate fluctuates greatly. The MakerDAO stability fee once reached a maximum of 20.5% and a minimum of only 0.5%.
yToken is a zero-coupon bond coinage 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. Different from traditional finance, a yToken can be custom-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 exchange the rights and interests of 1 DAI on a specific maturity date. For buyers, the floating interest rate of DAI can be exchanged for a fixed interest rate within a certain period through Yield.
For minters (sellers), 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, the value of the debt to be repaid will rise, and thus the value of the collateral assets in 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 minter can sell DAI to short it or do long arbitrage on the mortgage asset ETH.
If the minter expects that the price of the target asset DAI will drop for a period of time in the future, he can make a profit by selling DAI for shorting. If minters are optimistic that the price of the mortgage asset ETH will rise in the future, then they can increase their leverage in this way to increase exposure: traders can sell yDAI and buy more mortgage assets to generate yDAI, and repeat this operation many times to get Multiple times the leverage of mortgage assets. This is equivalent to increasing the long exposure of the mortgage asset (as opposed to increasing the short exposure of the target asset), and of course it also increases the liquidation risk.
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How to mint yTokens?
After understanding the basic principles of yToken, let us see how to mint yToken.
Taking the first application yDAI as an example, this token serves as a certificate of equity, allowing borrowers to mortgage ETH to issue yDAI with different redemption periods. The redemption period can be set to one week, one month or one year.
After the contract is deployed, anyone can deposit the mortgage asset ETH into the contract's vault (similar to MakerDAO's vault), mint yDAI, and each minting of new yDAI will increase the debt of the vault, and destroying yDAI will reduce the debt . A particular vault's debt cannot exceed the total amount of its collateral plus margin, or 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 are homogeneous and therefore can be sold and traded.
People who mint and sell yDAI are equivalent to borrowers: as minters, they deposit ETH collateral to mint yDAI, then sell to borrow the target asset DAI.
The buyer is the lender of the target asset DAI: by purchasing yDAI, lend DAI.
In the above case, yDAI with a face value of 1 may be purchased for only 0.97 DAI, and the holder, that is, the lender, can convert it into a face value of 1DAI on the maturity date to obtain a fixed income of 0.03DAI.
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Understanding on-chain interest rate oracles and interest rate curves
yTokens of the same target asset but with different maturities are homogeneous tokens, which means that they can be freely traded in the market, and the price is free to float based on supply and demand. Therefore, the annual interest rate for different maturities can be inferred based on market transaction prices.
Combining the discounted price and the maturity time, the annualized interest rate that will be obtained by purchasing yToken and holding it until maturity can be inferred. The deduction method is similar to calculating the interest rate from the price of a zero-coupon bond, 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 current value, and T is the number of years to maturity:
The interest rate can be used as an indicator of the spot interest rate of the target asset, providing a reference for lending agreement platforms such as Maker, Compound, and dYdX to determine the payment interest rate for a certain period. It can also be used to settle on-chain interest rate derivatives (such as swaps) if the price can be determined on-chain.
In addition, these data can also reflect market expectations, that is, how interest rates will change in the short term, which is the term structure of interest rates. In practical cases, the structure will also be affected by other factors, including liquidity or the perceived vulnerability risk 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 the lending agreement platforms of Maker, Compound, and dYdX, and at the same time, provide traders and analysts with the necessary information for investment operations and economic decision-making.
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The above interest rate curve can reflect the market's average expectation of the target asset interest rate in a certain period of time, but if they do not agree with these expectations, market participants can use this to make money-this is another use case of yToken: future interest rates speculate.
Taking yDAI and Chai (an ERC-20 token encapsulated in Maker's deposit contract to earn interest income by storing Dai) as examples, users can use Chai as collateral to mint yDAI. Since Chai is a smart contract that encapsulates DAI in the floating rate of DSR, holding Chai means owning the income right of DSR. Therefore, for the borrower, at this time, the DSR floating interest rate of holding CHAI can be obtained, and the fixed interest of yDAI needs to be paid at the same time.
If a trader believes that the floating interest rate of Chai will be higher than the fixed interest rate paid to yDAI in the future, and he is confident in his prediction, he can sell yDAI multiple times to obtain Chai and increase leverage to go long, so as to conduct speculative arbitrage.
On the contrary, if traders believe that the fixed interest rate of yDAI will be higher than the floating interest rate of Chai in the future, they can mint yCHAI by mortgaging yDAI for speculative arbitrage. At this time, for the borrower (minter), the fixed interest of the collateral yDAI can be obtained, and the floating interest of Chai must be paid to the buyer of yCHAI.
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Uniswap automatic market making mechanism can provide leveraged liquidity for yToken
The newly released Uniswap V2 version supports any ERC20 and ERC20 trading pairs, which means that liquidity can be provided for ERC20 and its underlying assets (if it is also an ERC20 standard) through Uniswap, such as yDAI/DAI.
For market makers, they earn transaction fees by contributing liquidity to specific yToken trading pairs, and since the prices of these assets at maturity can be roughly predicted, the risk of arbitrage due to volatility will be much smaller. Taking yDAI as an example, the token guarantees that a certain amount of DAI will be redeemed when it expires, which makes the future price of yDAI/DAI liquidity tokens predictable.
Going a step further, the DAI/yDAI pool can be used as collateral to mint yDAI. That is to say, traders can inject yDAI and DAI trading pairs into the Uniswap fund pool to contribute liquidity, use the reserve of the fund pool as collateral to repeatedly mint yDAI, and use leverage to do long multiple times on the liquidity reserve , to further increase the scale of assets. Since the risk coefficient of the DAI/yDAI capital 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 yTokens, to minting/burning, or trading yTokens with different expiration dates for arbitrage.
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Understand the settlement mechanism
For the zero-interest token yToken, one of the most important processes is the settlement mechanism, that is, how to determine a unified price for settlement 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 based on the synthetic asset settlement mechanism, which is applicable to the settlement of asset pairs supported by various DeFi lending platforms.
1. Cash settlement
Cash settlement, more precisely, is settlement with collateral assets. As a settlement mechanism, the premise of this mechanism is that there is an accurate price feed oracle that uses the collateral assets to denominate the target asset.
In this mechanism, yToken holders can redeem collateral assets of equivalent par value at maturity. Once it expires, anyone can call the function of the token contract to trigger the settlement, and then call the corresponding oracle to seek the current price of the target asset denominated in mortgage assets and store it as the settlement price. Afterwards, anyone can use the settlement price to exchange yTokens for a certain amount of equivalent collateral. In addition, upon maturity, any vault owner can withdraw the mortgaged assets net of debts 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 accurate price oracles are required for settlement.
2. Through auction physical settlement
If the target asset is a token in ERC20 format, yToken can be settled in kind, which means that yToken holders will be settled with the target asset.
This settlement mechanism is mainly realized through auctions. For each vault with outstanding debt, the mortgaged assets can be sold through a Dutch reverse auction to pay off the debt.
Suppose there is 1 ETH collateral in a vault at maturity, and a debt of 100 yDAI needs to be repaid. The protocol can start with an initial offer of 0.01 ETH/100 DAI and gradually increase the price until someone accepts it. The token DAI obtained in the auction will be distributed to yToken holders who have 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 backed by the target asset, rather than 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 borrowers to maintain their debt positions beyond maturity, leaving only the collateral remaining after the auction.
3. Settlement of synthetic assets
The synthetic asset settlement solution is the new content in this revision of the white paper, which can ensure the seamless settlement experience of synthetic assets without the need for oracle machines and auctions.
Specifically, when the underlying asset of yToken is a collateralized synthetic asset, such as DAI, when it expires, the issuance mechanism of the target synthetic asset will be used for settlement.
Specifically, when yDAI tokens expire, the protocol will send the ETH collateral in the Yield vault to the MakerDAO vault, and remint DAI based on the collateral, so as to meet the redemption target asset DAI of yDAI holders demand.
At this time, yDAI holders can redeem the loaned asset DAI, and the agreement will borrow DAI from Maker and pay the exchanger. Borrowers can still maintain their debt positions, but from now on they will switch from paying fixed interest rates to paying floating interest rates, which will be used by the agreement to pay Maker the stability fee for borrowing DAI. Until the borrower returns the DAI and closes the debt position, the agreement will also pay off Maker's debt, and the borrower will take back the collateral.
If the yDAI holder chooses to continue to hold and not pay, then the agreement starts to pay interest to the yDAI holder at a floating rate. In this case, after the ETH-backed yDAI expires, the protocol will start charging borrowers the Maker Stability Fee in ETH, while paying DSR to yDAI holders.
From another perspective, the mechanism is that after the maturity, the user's fixed-rate yToken position is transferred to the floating-rate debt.
The advantage of this mechanism is that both the borrower and the lender can continue to keep the previous position from being closed after maturity. The difference is that now they pay a floating interest rate instead of a fixed interest rate.
