Defi Project Spotlight: Euler Finance, The Next-generation Money Market

Key Takeaways

  • Euler Finance is a second-generation DeFi lending protocol {custom} constructed to permit permissionless lending and borrowing of long-tail crypto property.
  • Euler has innovated and constructed quite a lot of novel DeFi options, together with asset tiers, reactive rates of interest, risk-adjusted borrow elements, Dutch-auction liquidations, protected collateral, and batch transactions.
  • On Euler, anybody can create a cash marketplace for any crypto asset with an ETH liquidity pair on the Uniswap V3 decentralized trade.

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Euler Finance is a second-generation cash market protocol that introduces quite a lot of improvements to the DeFi area to allow permissionless lending and borrowing of crypto property. It’s designed to maximise capital effectivity and reduce 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 know Euler’s distinctive worth proposition, it’s value exploring DeFi’s present lending panorama. As we speak, 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 trying to earn curiosity on their crypto property can deposit them into Aave or Compound’s liquidity swimming pools to make them accessible for borrowing. However, customers trying to brief crypto property or tackle further leverage use these lending protocols to borrow.

Compound and Aave give attention to enabling lending and borrowing for a small variety of crypto property. The tokens accessible in each protocols are typically deemed as a number of the most secure in the marketplace. 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 authorised by governance by voting.

Whereas this considerably conservative strategy has its advantages, it leaves an unlimited 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 may 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 help of riskier property. “Euler was designed with a lot of improvements to extend capital effectivity and cut back danger. Particularly, it was designed or custom-built to deal with the dangers related to risky, long-tail tokens,” he stated. Since launching in December 2021, Euler has grown to help 74 property. It at present holds round $200 million in whole worth locked. 

Whereas permissionless markets definitely profit the trade, it’s value underscoring that additionally they introduce a myriad of dangers. Therefore, Euler needed to take into account all the perils and innovate through the constructing course of. 

How Euler Permits 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.

One in every of its key options is an asset classification system. It goals to mitigate the potential spillover affect liquidations might trigger by classifying property in response to their danger 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 proscribing 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 might spill over to a different and depart the protocol with unhealthy debt. Because of this, their itemizing necessities are a lot stricter. 

When property are first listed on Euler, they’re labeled as isolation-tier. Their tier may 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 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 major advantages: Uniswap’s TWAP is on-chain, that means it doesn’t require centralized intervention every time 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 stated that it was important if Euler was ever going to attain its purpose. “Whereas Compound and Aave act as gatekeepers over what property customers can lend or borrow as a result of they rely on centralized oracles like Chainlink, we constructed on high of Uniswap,” he stated. “You want a decentralized worth oracle when you’re ever going to have the ability to provide 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 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 characteristic 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 aircon. Equally, reactive rates of interest intention 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.”

Aave/Compound rates of interest (Supply: Euler)
Euler’s reactive rates of interest (Supply: Euler)

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 stage. In easy phrases, as an alternative of utilizing static fashions that alter a particular lending market’s rates of interest primarily based on the provision and demand for capital in response to 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 danger profile of the property, Euler has carried out 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 stated:

“We’re extraordinarily capital environment friendly in methods I feel Compound and Aave aren’t. Now we have one thing known as borrow elements, which allow the quantity of borrowing energy a consumer has to rely on 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 sometimes depend on so-called collateral elements that decide the quantity customers can borrow primarily based 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 a degree 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 about (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 with regards to borrowing safer tokens, it doesn’t account for the danger 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 secure 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 might 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 danger issue of the borrowed asset, a consumer might borrow $900 value of ETH ($1,000 x 0.9), placing their place at the next danger of liquidation. For property additional to the proper 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 hard and fast 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 eradicate fuel wars between would-be liquidators. 

Aave and Compound provide a hard and fast 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 detrimental externalities for the broader ecosystem. 

Furthermore, fastened reductions may 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 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 completely different liquidators have completely different danger and reward expectations, they theoretically decide completely different instances to liquidate, circumventing any must wage fuel wars. Nevertheless, 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 high 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.

In contrast to different lending protocols, Euler implements a particular deposit class known as protected collateral, which lets customers deposit property with out instantly making them accessible for lending. By leveraging this characteristic, customers can safely pledge governance tokens as collateral, figuring out that different customers received’t be capable of borrow them to affect governance selections or take brief positions. Commenting on this characteristic, Bentley stated:

“For property like MKR or different governance tokens, individuals don’t deposit them on cash markets as a result of they’re fearful individuals 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 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 advanced place administration with out being constrained by inflexible collateral circumstances. The place different lending protocols verify an account’s liquidity at first of an operation, Euler customers can instruct the protocol to verify 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, reap the benefits of arbitrage alternatives throughout DeFi, rebalance positions, execute advanced 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 to avoid wasting on fuel charges. As well as, the protocol implements a intelligent solution to simplify taking over 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.

Remaining Ideas

In a sea of forks and copycat protocols, Euler is likely one of 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 property—has by no means been addressed within the area earlier than. Euler’s utilization information 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 shouldn’t be essentially a superior product to earlier lending protocols. Fairly, it’s a unique one which fills a spot within the lending market that different protocols missed. 

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

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