Lender Beware Pt 3. - Lending Pairs
Shared-pool lending platforms spearheaded the development of lending in the cryptocurrency space and decentralized finance would not be the same without Aave and its compatriots. However, the systemic risk that this approach cannot exist without places limitations on its ability to function in a permission-less way. The lending pair approach recognises this issue and provides a way for a lending market to be provided for ANY token (much in line with the ethos of Defi).
Lending pairs allow for isolated markets where users only take on risk from chosen collateral (as opposed to shared-pools)
Isolated risk allows for listing of long-tail assets including unconventional assets such as LP tokens
Degree of isolation with pure lending pairs results in fractured liquidity that significantly compromises usability
Tailored lending pairs concentrate liquidity of tokens with a single asset and allow for far greater capital efficiency
What is a Lending Pair Platform?
Whilst there are several variations to lending pair platforms, the core mechanism allows users to create individual markets denominated Token A/Token B. What this means is that any lender with Token A can deposit Token A into the pair and earn interest. On the other end, borrowers who hold Token B can deposit it as collateral to borrow Token A. The benefit of this is that if Token C experiences an exploit, Token A lenders in the Token A/Token B pair are unaffected since it does not accept Token C as collateral - in effect, risk is isolated to whatever collateral is selected.
Pure Lending Pair Approach
Lending pairs in its purest form can be seen on Kashi Finance, a lending market built on the Sushiswap platform. On Kashi, a user that holds Token A can deposit it into any Token A/Token XYZ pair and start earning interest. If no pair exists, they can create their own market. The lender has complete control over which collateral they accept which allows them to adjust the risk they are exposed to. If they wish to accept $SHIT as collateral, power to them, but for others $USDC may be a more appropriate collateral - lenders take responsibility for highly volatile or non-liquid collateral in the event of liquidations.
Whilst at face-level permission-less lending market creation provides an excellent solution for long-tail assets, it actually introduces a level of complexity that compromises the usability of lending pair approaches. For every Token A that accepts $ETH as collateral, there may be another Token A that accepts $USDC, or $WBTC, or $UNI. The creation of new money markets for every combination of Token A/Token XYZ pairings spreads the Token A liquidity thinly across its isolated markets. The result is poor utilization of deposited funds and subsequently poor interest rates which makes lending on pure lending pair platforms inefficient and unattractive to lenders.
Tailored Lending Pair Approaches
Abracadabra is a lending platform that actually uses Kashi’s lending pair technology to create a stablecoin ecosystem for a select group of collateral assets in exchange for MIM, Abracadabra’s stablecoin which is pegged to $1 USD. What is really cool about Abracadabra is that the collateral assets accepted include interest-bearing tokens such as xSushi, yvUSDC, and even LP tokens such as cvx3pool. This allows users to collateralise assets that are already generating interest and leverage this capital to generate value in other places, creating two potential income streams from the same underlying assets.
The MIM peg is maintained through overcollateralization and integration with Curve Finance, a platform that allows users to swap pegged assets at high volume with very low slippage. The two primary pools for MIM on Curve are MIM-UST and MIM+3CRV. MIM-UST allows users to swap MIM for Luna’s UST stable coin whilst the MIM+3CRV allows users to swap MIM for 3CRV LP Tokens. 3CRV LP Tokens can be swapped in the Curve 3 Pool for DAI, USDC, or USDT. This effectively allows a borrower’s underlying tokens to be collateralized for MIM and converted into other stablecoins to be used elsewhere.
Abracadabra is a highly efficient platform for the tokens that are listed. However, it is not a true lending platform since users can actually only borrow MIM. MIM is printed by the protocol itself rather than provided by lenders - despite using a lending pair approach, lenders looking to just earn interest must look elsewhere. It has also been the subject of significant controversy in the past few weeks due to sell-offs in its collateral assets causing cascading liquidations of borrower’s funds.
Tips for Selecting a Lending Pair Platform
Choose the right collateral: Whilst bad debt risk is isolated, it is isolated to your choice of collateral. If you choose collateral with low liquidity and vulnerable oracles, you could be exposed to even greater risk than just using a shared-pool platform.
Be aware of its limitations: Fractured liquidity ultimately plays into usability of lending pairs. Its degree of isolation compromises utilization rate which in turn compromises interest rate for lenders. Even if lending markets can be created for all possible collateral, not all collaterals will have interest rates that are competitive.
Pure lending pairs introduce unparalleled security in comparison to its shared-pool predecessors. However, in its current iteration, it is prohibitively inefficient due to fractured liquidity. Tailored lending pairs such as Abracadabra introduced capital efficiency by denominating all loans in a single token. This creates a highly efficient system that allows anyone with a supported asset to collateralise their capital. As a pure borrowing system, however, it does not fill the void for lenders.
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