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

Euler Finance is a second-generation cash market protocol that introduces quite a lot of improvements to the DeFi house to allow permissionless lending and borrowing of crypto property. 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 property.

To grasp Euler’s distinctive worth proposition, it’s price exploring DeFi’s present lending panorama. Right now, the 2 dominant decentralized lending protocols are Aave and Compound. Collectively, they seize about 50% of the full market share, respectively holding about $6.06 billion and $2.79 billion in total value locked. Customers trying to earn curiosity on their crypto property can deposit them into Aave or Compound’s liquidity swimming pools to make them obtainable for borrowing. However, customers trying to brief crypto property 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 property. The tokens obtainable in each protocols are typically deemed as among the most secure available on the market. Neither protocol was designed to deal with the dangers related to extra risky, illiquid crypto property. As a substitute, each protocols depend on a permissioned itemizing system whereby any new tokens aspiring to get listed should first be authorized by governance by voting.

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

Crypto Briefing related with Euler Finance co-founder and CEO Michael Bentley to study in regards to the protocol, and he started by highlighting the protocol’s assist of riskier property. “Euler was designed with plenty of improvements to extend capital effectivity and cut back threat. Particularly, it was designed or custom-built to deal with the dangers related to risky, long-tail tokens,” he mentioned. Since launching in December 2021, Euler has grown to assist 74 property. It presently holds round $200 million in whole worth locked. 

Whereas permissionless markets definitely profit the trade, it’s price underscoring that in addition they introduce a myriad of dangers. Therefore, Euler needed to contemplate 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 progressive options.

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

By isolating the riskiest property and limiting their use as collateral, Euler can permit 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 go away the protocol with dangerous debt. Because of this, their itemizing necessities are a lot stricter. 

When property are first listed on Euler, they’re categorized as isolation-tier. Their tier could be modified pending a governance vote. There are presently 59 isolation-tiered markets, 11 cross-tiered markets, and 7 collateral-tiered markets.

Moreover, Euler makes use of Uniswap V3’s Time Weighted Common Value (TWAP) on-chain oracle answer to supply its worth feeds as an alternative of counting on centralized oracle suppliers like Chainlink. This strategy has two principal 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 worth manipulations than different centralized alternate options.

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

One other characteristic that makes Euler distinctive amongst lending protocols is its implementation of reactive rates of interest, which clear up the issue of manually figuring out the right parameters for each lending market. “We pioneered reactive rates of interest that just a few different protocols have now copied and applied,” Bentley mentioned, explaining that the characteristic works like a thermostat. He mentioned:

“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 scorching, it turns up the aircon. Equally, reactive rates of interest intention to stabilize the utilization ratio of swimming pools and due to this fact improve 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–spinoff (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 precise lending market is above or under a particular utilization goal degree. In easy phrases, as an alternative of utilizing static fashions that alter a particular lending market’s rates of interest based mostly 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.

Danger-Adjusted Borrowing Capability

In addition to the collateral elements that decide borrowing capability based mostly on the danger profile of the property, Euler has applied a two-sided strategy that additionally considers the danger profile of the borrowed property or liabilities to mitigate the dangers related to the permissionless borrowing and lending of long-tail crypto property. Explaining this characteristic, Bentley mentioned:

“We’re extraordinarily capital environment friendly in methods I feel Compound and Aave aren’t. We have now one thing referred to as borrow elements, which allow the quantity of borrowing energy a consumer has to depend upon each the asset they’re borrowing and the collateral they’re offering. If you consider it, for a lending protocol that caters to the long-tail finish of the market, it solely is smart to contemplate the danger issue of the borrowed property.”

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 usually depend on so-called collateral elements that decide the quantity customers can borrow based mostly on the danger profile of the property 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 checklist much less dangerous tokens, the loan-to-value ratio is set based mostly on the collateral’s threat issue alone. For instance, if a consumer needs to pledge $1,000 price of ETH as collateral to borrow wBTC, when the collateral issue for ETH is about (by governance) at 0.7, the consumer can solely borrow $700 price 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 method may match effectively in terms of borrowing safer tokens, it doesn’t account for the danger of borrowing extra obscure, riskier tokens. In response, Euler has applied a two-sided strategy that introduces borrow elements along with collateral elements. 

On Euler, if a consumer has $1,000 price of USDC, a steady asset with a excessive collateral issue of 0.9, and desires to borrow ETH, a extra risky asset with a decrease borrow issue of 0.7, the consumer may borrow as much as $630 price 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 danger issue of the borrowed asset, a consumer may borrow $900 price of ETH ($1,000 x 0.9), placing their place at the next threat of liquidation. For property additional to the correct on the danger 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 an alternative 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 in addition get rid of fuel 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 worth, these hoping to liquidate the collateral rush in on the similar time to seize the premium. This results in precedence fuel auctions as a part of DeFi’s so-called MEV wars, which produces destructive externalities for the broader ecosystem. 

Furthermore, fastened reductions could be extreme for big debtors who are suffering a liquidation, probably discouraging them from ever utilizing the protocols sooner or later. On the similar time, they could even be too small to incentivize smaller liquidations, probably leaving the protocol with dangerous money owed. 

Euler’s Dutch public sale course of permits the scale of the low cost to extend relying on how underwater a place is. As totally different liquidators have totally different threat and reward expectations, they theoretically decide totally different instances to liquidate, circumventing any must wage fuel 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 in opposition to 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 embody 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 property with out instantly making them obtainable for lending. By leveraging this characteristic, customers can safely pledge governance tokens as collateral, realizing that different customers gained’t have the ability to borrow them to affect governance selections or take brief positions. Commenting on this characteristic, Bentley mentioned:

“For property 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. For that reason, we created a specifically protected asset class the place customers can deposit an asset as collateral—however nobody can borrow it. This manner, we will have a standard 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 govern the MakerDAO’s governance.”

Deferred liquidity checks, then again, let customers execute complicated place administration with out being constrained by inflexible collateral situations. The place different lending protocols test an account’s liquidity firstly 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 an alternative 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, benefit from 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 enables customers to batch transactions and submit them unexpectedly to avoid wasting on fuel charges. As well as, the protocol implements a intelligent method to simplify taking up leverage. For instance, as an alternative 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 through self-collateralized loans.

Ultimate Ideas

In a sea of forks and copycat protocols, Euler is without doubt one of the uncommon youthful DeFi tasks that really stands out by introducing new options to the decentralized lending house. The important thing drawback it solves—enabling a permissionless cash market custom-designed for long-tail property—has by no means been addressed within the house 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 price noting that Euler shouldn’t be essentially a superior product to earlier lending protocols. Quite, it’s a special one which fills a niche within the lending market that different protocols missed. 

Disclosure: On the time of writing, the writer of this piece owned ETH and several other different cryptocurrencies.