Lender Beware Pt 4. - The Siloed Solution
Success and relevance in decentralized finance is a constant journey of iteration that allows developers to build upon concepts of previous protocols and improve them to produce a product that is safer and more efficient for end users.
The lending space is an area that has fully captured this process. Pure shared-pools introduced the notion of lending in a highly efficient manner but the systemic risk limits token offerings. Isolated shared-pools allow for long-tail assets but have been the subject of large liquidations in entire pools due to a single volatile asset. Pure lending pairs isolate risk completely but have poor usability owing to fractured liquidity.
Ultimately, there is a trilemma of lending that has yet to be solved:
Isolated risk: lenders should only be exposed to risk in token(s) that they fully trust
Concentrated liquidity: liquidity should be concentrated to allow for maximum utilisation (and interest) and thus usability for both lenders and borrowers
Permission-less: tokens should have access to a lending market without the need for white-listing
Silo Finance has had the opportunity to learn from these pressure points to devise a solution that aims to solve this trilemma - introducing the Siloed approach.
Lending Pairs - The Foundation
From the previous article, you may recall that a lending pair approach is significantly safer than a shared-pool approach due to risk isolation. Lenders can choose exactly which collateral borrowers can use which allows the creation of long-tail asset lending markets without the need for governance whitelisting. The key drawback, however, is fractured liquidity - users lending a single asset may have different collateral preference and each preference opens a new market. This can create a scenario where even if there is high liquidity for a token on a platform, the liquidity in each pair is spread so thin that it cannot function effectively.
Bridged Lending Pairs - The Solution
Lending pairs are permission-less and allow isolated risk at the expense of platform usability. This is owing to the fact that different lenders may have different preferences for what constitutes collateral. Even if that collateral is a stablecoin, there are now so many to choose from that would each introduce a new lending market and further fracture liquidity.
Rather than allowing for unlimited pairings, Silo creates a single lending pair for each individual token. These tokens are combined with a bridge asset which is currently ETH with plans to expand to USDs with the most recent proposal, a Silo stablecoin that will be fully collateralized by a basket of other stablecoins. Denominating the lending pairs in the bridge assets allows the platform to concentrate liquidity fully whilst maintaining risk isolation, allowing for permission-less listing of any token - provided that lenders trust ETH and USDs as collateral, there is very limited risk to lender funds. In addition, since every silo is denominated in the same bridge assets, borrowers can move freely between any two silos by using the bridge assets as an intermediary.
How will borrowing and lending actually work?
Whilst most lending protocols only have two parties, Silo actually has three - lenders, bridge providers, and borrowers.
Lenders holding any token can do single-side deposits into their corresponding silo. As opposed to pure lending pairs, they do not have to select collateral - it will automatically be combined with ETH and USDs (pending a successful governance vote) which will be provided by bridge providers. Since liquidity for a token is concentrated in a single silo, they can expect far greater utilization and thus interest than lending pair platforms.
Bridge providers deposit ETH or USDs into a silo or silos. Their choice in silo exposes them to risk - if they choose to support tokens that are highly volatile or experience oracle exploits, they run the risk of debt non-repayment. As such, bridge providers should only support tokens they trust or they think the interest rate adequately compensates them for the risk. Bridge providing will be highly flexible and users will be able to select a single silo or multiple silos to support - the more silos they support the higher the interest but the higher the risk.
Borrowers can use any token to borrow the bridge asset(s) and then use the bridge asset to borrow from any other silo (if they start with the bridge asset they can just borrow directly). Since liquidity is concentrated rather than fractured, it is significantly easier to borrow large amounts from a single silo rather than requiring several types of collateral for large borrowings in pure lending pairs. However, borrowers will need to keep track of two collateral ratios to safely avoid liquidations.
What are the risks involved?
In lending pairs, lenders are at risk of bad debt if their chosen collateral is exploited. The collateral for every silo is ETH and USDs which in general can be considered safe - an exploit in ETH would have far-reaching consequences that affect the whole Defi space. USDs as a fully collateralized stablecoin should be able to maintain its peg but will require deep liquidity in an AMM such as Curve or Balancer.
Bridge providers are the true risk taker. They have the option to act as the bridge asset for any silo or silos and will be affected if the underlying token(s) are exploited. It is their responsibility to only bridge for tokens that they trust.
For borrowers going from Token A → Bridge Asset → Token B, they will need to keep an eye on two collateral ratios since two borrow positions are actually taken. Failure to track collateral positions can cause liquidations that may incur a penalty.
Tips for using Silo Finance
The most important thing is to identify the risk you are exposed to based on which party you are:
Lenders: so long as USDs and ETH do not experience exploits, your deposits are safe
Bridge-Providers: your interest received and risk is determined by the silos you choose to support. Only select silos that contain a token you are comfortable with.
Borrowers: make sure you maintain collateral health to minimize risk of liquidation
Read more in this series: