DeFi Project Spotlight: Euler Finance, the Next-Generation Money Market

Euler Finance is a second-generation cash market protocol that introduces numerous improvements to the DeFi area to allow permissionless lending and borrowing of crypto belongings. It’s designed to maximise capital effectivity and decrease the dangers related to the lengthy tail of the market.

Euler Finance Defined

Euler Finance is a novel lending protocol constructed to allow permissionless borrowing and lending of risk-on, long-tail crypto belongings.

To know Euler’s distinctive worth proposition, it’s value exploring DeFi’s present lending panorama. Right this moment, the 2 dominant decentralized lending protocols are Aave and Compound. Collectively, they seize about 50% of the entire market share, respectively holding about $6.06 billion and $2.79 billion in total value locked. Customers seeking to earn curiosity on their crypto belongings can deposit them into Aave or Compound’s liquidity swimming pools to make them accessible for borrowing. However, customers seeking to quick crypto belongings or tackle extra leverage use these lending protocols to borrow.

Compound and Aave concentrate on enabling lending and borrowing for a small variety of crypto belongings. The tokens accessible in each protocols are typically deemed as a few of the most secure in the marketplace. Neither protocol was designed to deal with the dangers related to extra unstable, illiquid crypto belongings. As a substitute, each protocols depend on a permissioned itemizing system whereby any new tokens aspiring to get listed should first be permitted by governance by way of voting.

Whereas this considerably conservative strategy has its advantages, it leaves an enormous portion of the conceivable lending and borrowing market fully unserved. That is the place Euler is available in. Euler is a permissionless cash market protocol designed to serve the intensive long-tail finish of the market. On Euler, each token with an ETH liquidity pair on Uniswap V3 will be listed and made accessible for borrowing and lending. 

Crypto Briefing linked with Euler Finance co-founder and CEO Michael Bentley to study concerning the protocol, and he started by highlighting the protocol’s assist of riskier belongings. “Euler was designed with numerous improvements to extend capital effectivity and scale back danger. Particularly, it was designed or custom-built to deal with the dangers related to unstable, long-tail tokens,” he stated. Since launching in December 2021, Euler has grown to assist 74 belongings. It at present holds round $200 million in whole worth locked. 

Whereas permissionless markets actually profit the business, it’s value underscoring that in addition they introduce a myriad of dangers. Therefore, Euler needed to think about all the perils and innovate in the course of the constructing course of. 

How Euler Allows Permissionless Asset Itemizing

To construct a permissionless lending protocol that maximizes capital effectivity whereas mitigating potential dangers, Euler got here up with a spread of revolutionary options.

Certainly one of its key options is an asset classification system. It goals to mitigate the potential spillover impression liquidations may trigger by classifying belongings in accordance with their danger profiles. Belongings are divided into three tiers: isolation-tier, cross-tier, and collateral-tier. Isolation-tier belongings can’t be used as collateral, nor can they be borrowed from the identical account alongside some other belongings. Cross-tier belongings, which fall extra on the left-hand facet of the chance curve, can’t be used for collateral, however they are often borrowed alongside different cross and collateral-tier belongings. Lastly, collateral-tier belongings are the one belongings that can be utilized as collateral.

By isolating the riskiest belongings and proscribing their use as collateral, Euler can enable permissionless itemizing and run cash markets with out endangering the entire protocol. First-generation lending protocols like Aave can’t take this strategy as a result of a possible liquidation cascade in a single market may spill over to a different and depart the protocol with unhealthy debt. Because of this, their itemizing necessities are a lot stricter. 

When belongings are first listed on Euler, they’re labeled as isolation-tier. Their tier will be modified pending a governance vote. There are at present 59 isolation-tiered markets, 11 cross-tiered markets, and 7 collateral-tiered markets.

Moreover, Euler makes use of Uniswap V3’s Time Weighted Common Worth (TWAP) on-chain oracle resolution to supply its value feeds as a substitute of counting on centralized oracle suppliers like Chainlink. This strategy has two major advantages: Uniswap’s TWAP is on-chain, that means it doesn’t require centralized intervention at any time when a brand new lending market is created on Euler. Secondly, executing financial assaults on lending markets leveraging Uniswap’s TWAP oracle is capital-intensive, that means the protocol is extra proof against potential exploits involving value manipulations than different centralized options.

Commenting on this design selection, Bentley stated that it was important if Euler was ever going to attain its aim. “Whereas Compound and Aave act as gatekeepers over what belongings customers can lend or borrow as a result of they rely upon centralized oracles like Chainlink, we constructed on prime of Uniswap,” he stated. “You want a decentralized value oracle in the event you’re ever going to have the ability to supply permissionless lending and borrowing.“

One other function that makes Euler distinctive amongst lending protocols is its implementation of reactive rates of interest, which remedy the issue of manually figuring out the proper parameters for each lending market. “We pioneered reactive rates of interest that a couple of different protocols have now copied and carried out,” Bentley stated, explaining that the function works like a thermostat. He stated:

“Reactive rates of interest are a mechanism to extend the capital effectivity of lending markets. They work equally to how a thermostat regulates the temperature in your own home: you set the specified temperature and, if it’s chilly exterior, the thermostat turns up the warmth; if it’s sizzling, it turns up the air conditioning. Equally, reactive rates of interest purpose to stabilize the utilization ratio of swimming pools and subsequently enhance the capital effectivity of the protocol as a result of lenders get a greater worth for cash on Euler than elsewhere.”

Particularly, Euler makes use of a proportional–integral–by-product (PID) controller to amplify or dampen the speed of change within the rates of interest relying on whether or not the utilization ratio for the particular lending market is above or beneath a particular utilization goal stage. In easy phrases, as a substitute of utilizing static fashions that modify a particular lending market’s rates of interest primarily based on the availability and demand for capital in accordance with pre-set or hardcoded parameters, Euler makes use of a extra versatile, reactive mannequin that targets a particular utilization ratio, making the protocol extra capital environment friendly.

Threat-Adjusted Borrowing Capability

In addition to the collateral elements that decide borrowing capability primarily based on the chance profile of the belongings, Euler has carried out a two-sided strategy that additionally considers the chance profile of the borrowed belongings or liabilities to mitigate the dangers related to the permissionless borrowing and lending of long-tail crypto belongings. Explaining this function, Bentley stated:

“We’re extraordinarily capital environment friendly in methods I believe Compound and Aave aren’t. We’ve one thing referred to as borrow elements, which allow the quantity of borrowing energy a consumer has to rely upon each the asset they’re borrowing and the collateral they’re offering. If you concentrate on it, for a lending protocol that caters to the long-tail finish of the market, it solely is smart to think about the chance issue of the borrowed belongings.”

Lenders on decentralized cash markets can’t confirm whether or not debtors are creditworthy, which is why borrowing in DeFi tends to be overcollateralized. Lending protocols sometimes depend on so-called collateral elements that decide the quantity customers can borrow primarily based on the chance profile of the belongings they’re pledging as collateral. When the loan-to-value ratio drops past a sure threshold and begins approaching some extent the place it turns into inadequate to cowl the borrowed quantity, the place is marked for liquidation.

In first-generation lending protocols that solely record much less dangerous tokens, the loan-to-value ratio is set primarily based on the collateral’s danger issue alone. For instance, if a consumer needs to pledge $1,000 value of ETH as collateral to borrow wBTC, when the collateral issue for ETH is ready (by governance) at 0.7, the consumer can solely borrow $700 value of wBTC. If the worth of the ETH collateral drops to $700, or the worth of the wBTC legal responsibility rises to $1,000, the place will get marked for liquidation.

Whereas this technique may go effectively in the case of borrowing safer tokens, it doesn’t account for the chance of borrowing extra obscure, riskier tokens. In response, Euler has carried out a two-sided strategy that introduces borrow elements along with collateral elements. 

On Euler, if a consumer has $1,000 value of USDC, a steady asset with a excessive collateral issue of 0.9, and desires to borrow ETH, a extra unstable asset with a decrease borrow issue of 0.7, the consumer may borrow as much as $630 value of ETH. The quantity is calculated by multiplying the USDC collateral by the 2 borrowing elements ($1,000 x 0.9 x 0.7). On Compound, which doesn’t account for the chance issue of the borrowed asset, a consumer may borrow $900 value of ETH ($1,000 x 0.9), placing their place at the next danger of liquidation. For belongings additional to the proper on the chance curve, Euler has even decrease borrow elements. For instance, the borrow issue for Synthetix’s SNX token is 0.28.

Environment friendly Liquidation Engine

Talking of liquidations, Euler has innovated on this vertical too. Particularly, as a substitute of providing the borrower’s collateral to liquidators at a set percentage-based low cost, as Aave and Compound do, Euler runs Dutch public sale liquidations, that are far much less punitive for debtors and likewise remove gasoline wars between would-be liquidators. 

Aave and Compound supply a set 5 to 10% low cost for liquidations, so when the consumer’s collateral breaks previous the liquidation value, these hoping to liquidate the collateral rush in on the similar time to seize the premium. This results in precedence gasoline auctions as a part of DeFi’s so-called MEV wars, which produces detrimental externalities for the broader ecosystem. 

Furthermore, fastened reductions will be extreme for giant debtors that suffer a liquidation, doubtlessly discouraging them from ever utilizing the protocols sooner or later. On the similar time, they could even be too small to incentivize smaller liquidations, doubtlessly leaving the protocol with unhealthy money owed. 

Euler’s Dutch public sale course of permits the dimensions of the low cost to extend relying on how underwater a place is. As totally different liquidators have totally different danger and reward expectations, they theoretically decide totally different occasions to liquidate, circumventing any must wage gasoline wars. Nonetheless, as a result of miners or so-called “seekers”—brokers specializing in MEV extraction—can front-run and steal a liquidator’s transaction, Euler incentivizes the debtors to grow to be liquidators by assigning them low cost boosters. This offers the debtors a bonus towards front-runners by making them extra worthwhile within the Dutch public sale.

Euler’s UX-Centered Improvements

On prime of the core differentiating options, Euler has launched a number of smaller improvements to enhance the platform’s consumer expertise. These embrace protected collateral, deferred liquidity checks, fee-free flash loans, an in-house transaction builder, sub-accounts, and environment friendly leverage.

Not like different lending protocols, Euler implements a particular deposit class referred to as protected collateral, which lets customers deposit belongings with out instantly making them accessible for lending. By leveraging this function, customers can safely pledge governance tokens as collateral, figuring out that different customers received’t be capable to borrow them to affect governance choices or take quick positions. Commenting on this function, Bentley stated:

“For belongings like MKR or different governance tokens, folks don’t deposit them on cash markets as a result of they’re anxious folks will borrow them to vote and manipulate the governance of those protocols. Because of this, we created a specifically protected asset class the place customers can deposit an asset as collateral—however nobody can borrow it. This manner, we are able to have a traditional MKR market and a protected MKR market the place customers can use MKR as collateral with out worrying that anybody can use their tokens to control the MakerDAO’s governance.”

Deferred liquidity checks, alternatively, let customers execute complicated place administration with out being constrained by inflexible collateral situations. The place different lending protocols test an account’s liquidity initially of an operation, Euler customers can instruct the protocol to test it solely as soon as on the finish of their operation. For instance, as a substitute of getting to pledge collateral earlier than borrowing, by deferring liquidity checks on Euler, customers can borrow with out pledging any collateral, carry out an operation, and repay the mortgage inside one transaction. This successfully permits customers to execute free flash loans to construct up leveraged positions, make the most of arbitrage alternatives throughout DeFi, rebalance positions, execute complicated trades, and so forth.

Euler has additionally constructed a transaction builder contained in the consumer interface that permits customers to batch transactions and submit them unexpectedly to avoid wasting on gasoline charges. As well as, the protocol implements a intelligent technique to simplify taking over leverage. For instance, as a substitute of asking customers to execute a number of transactions on a loop to lever up, Euler lets them use the protocol’s mint perform to conduct all of their actions in a single transaction. The mint perform creates an equal quantity of deposits and money owed for an account, permitting customers to lever up in a single transaction by way of self-collateralized loans.

Ultimate Ideas

In a sea of forks and copycat protocols, Euler is among the uncommon youthful DeFi initiatives that actually stands out by introducing new options to the decentralized lending area. The important thing downside it solves—enabling a permissionless cash market custom-designed for long-tail belongings—has by no means been addressed within the area earlier than. Euler’s utilization knowledge signifies that there’s a sturdy natural demand for such a product regardless of DeFi’s year-long bear market.

To that time, it’s value noting that Euler just isn’t essentially a superior product to earlier lending protocols. Somewhat, it’s a distinct one which fills a niche within the lending market that different protocols missed. 

Disclosure: On the time of writing, the creator of this piece owned ETH and a number of other different cryptocurrencies.