Pantera Partners Interpret Notional Finance: A DeFi Fixed Rate Lending Protocol

Author: VeradiVerdict, Pantera Capital

Compiled by: Lu Jiangfei, Chain News

Yesterday, a friend asked me where he could deposit Bitcoin and Ethereum and borrow stablecoins at a fixed interest rate and fixed term. I told him to wait for this article!

Notional Finance recently completed a Series A funding round, led by Pantera Capital. This project is addressing the problem my friend encountered: allowing people (especially during bear markets) to avoid selling their cryptocurrencies or giving up their related asset positions to borrow funds for daily expenses.

Currently, most DeFi lending protocols in the market offer variable interest rate lending, meaning that the loan interest rate can change during the loan term. For example, in December 2020, the loan interest rate for USDC on a well-known DeFi lending protocol Aave fluctuated between 2% and 65%. Due to this high volatility and low confidence in interest rates, floating rate loans are often considered risky.

In contrast, fixed-rate loans hold a significant share in the global lending market, where the interest rate remains constant throughout the loan period. Because the known interest rate is predetermined, fixed-rate loans carry less risk, attracting a broader range of use cases with longer durations and lower risks.

For cryptocurrencies on the Ethereum blockchain, there is now a decentralized fixed-rate term loan protocol: Notional Finance. Users can borrow and lend funds using stablecoins DAI and USDC or provide liquidity to the protocol. For six-month loans, the annualized interest rate offered by the Notional Finance protocol is very competitive compared to other market competitors, around 6-7%.

The corresponding token for the Notional Finance protocol is "fCash," which is defined by two key elements: 1. the associated cryptocurrency; 2. the maturity date. In the background, the Notional Finance protocol deploys several liquidity pools between fCash and supported assets, using a custom automated market maker (AMM) to support fixed-rate loans.

Borrowers can withdraw assets from the Notional Finance protocol, and in exchange, they receive a negative balance of fCash for the associated cryptocurrency (also based on a fixed rate). On the maturity date, the fCash balance requires the borrower to return an equivalent amount of the associated cryptocurrency to the protocol.

Lenders can deposit assets into the Notional Finance protocol, and in exchange, they receive fCash tokens associated with the cryptocurrency (also based on a fixed rate). On the maturity date, lenders can redeem these fCash tokens for an equivalent amount of the associated cryptocurrency.

The Notional Finance protocol has opened a new use case in the DeFi space, namely fixed-rate lending services, which have been well received by many users, especially those averse to risk and unwilling to take on long-term debt. Some applications exploring fixed-rate loans have already emerged on the Notional Finance protocol, primarily including: 1. Funding low-risk, low-return trading strategies; 2. Providing early sustainable liquidity for new DeFi projects; 3. Using crypto assets to pay off personal loans such as mortgages.

Undoubtedly, DeFi is capturing more market share in the global financial ecosystem. In this process, platform-based fixed-rate crypto loan products are crucial. For the fixed-rate debt market operating on the Ethereum blockchain, the Notional Finance protocol has already provided a promising model that allows users to borrow and lend cryptocurrencies at lower risks than ever before, while also greatly expanding the use cases of DeFi.

What is Notional Finance?

For cryptocurrencies on the Ethereum blockchain, Notional Finance is a decentralized fixed-rate term loan protocol. Since its launch last fall, the protocol has locked over $19.5 million in assets and processed $9.5 million in loan funds. By building a fixed-rate debt market platform on the Ethereum blockchain, Notional Finance aims to introduce a new set of financial use cases in the decentralized finance space, namely retail loans (a service widely used in mainstream financial markets).

Currently, Notional Finance supports borrowing and providing liquidity with two stablecoins, DAI and USDC, with fixed interest rates throughout the loan term. However, the interest rates may vary based on different borrowing conditions, which mainly include: loan size, chosen base stablecoin, and loan term length.

For a six-month loan, the fixed annual interest rate typically offered by the Finance protocol is around 6-7%.

Some Use Cases for Fixed-Rate Loans in DeFi

As of the writing of this article, the total outstanding debt of DeFi lending protocols is approximately $19 billion. In contrast, the total size of the U.S. debt market is estimated at $46 trillion, while the global debt market is estimated at $128 trillion.

Outside of DeFi, most debt markets are driven by fixed-rate loans, which are loans provided at a fixed, unchanging interest rate. Fixed-rate loans typically reduce risk because these loan contracts allow lenders and borrowers to have more confidence in their borrowing and repayment, enabling them to formulate long-term strategies and leverage trading positions. This is why fixed-rate loans dominate countless classic financial use cases (e.g., mortgages, corporate loans, and public bonds).

In contrast, most lending protocols in the DeFi space offer variable-rate lending, where the interest rates of related lending products can change at any time during the loan term. However, to use these lending protocols, one must hold (or exchange) crypto assets. Therefore, once the cryptocurrency market experiences high volatility, it often triggers significant fluctuations in the interest rates of these lending products, further amplifying the risks of variable-rate loans. If you want to achieve long-term investment returns through DeFi lending, these variable-rate lending products are actually unreliable.

For example, Aave, one of the largest DeFi lending protocols in the crypto market, saw the annualized yield of their USDC loan products fluctuate between 2% and 70% during December 2020. For ordinary investors seeking low-risk and reliable investments, such high volatility is not what they expect to see.

Figure 1: USDC borrowing rate trends on the Aave platform in December 2020

In this context, to better apply cryptocurrencies to the financial debt market, lending protocols must offer fixed-rate lending services to attract more traditional non-crypto users and expand the range of use cases.

Currently, some crypto projects in the market provide fixed-rate crypto loan services through centralized finance, where lending institutions effectively play a role similar to that of central banks. We know that in traditional financial models, people need to use fiat currency to hold and exchange loan assets, while crypto lending institutions based on centralized finance use cryptocurrencies.

For example, BlockFi is a crypto lending service provider based on a centralized finance model, managing assets worth $15 billion, which fully demonstrates the significant demand in the market. However, centralized finance-based crypto lending protocols still face some key issues, such as:

• Low accessibility (similar to the issues faced by most traditional banking services)
• Poor transparency
• Significant counterparty risk (any lending service agent could default in financial transactions)

In other words, those crypto loan agents based on centralized finance models may have default risks in financial transactions. For instance, the crypto lending service provider Cred had to declare bankruptcy in 2020 due to a series of poor pledges and fraudulent transactions, ultimately resulting in liquidity providers losing over $100 million.

Decentralized finance is fundamentally different from centralized finance. Because DeFi protocols are transparent, automated, and decentralized, and benefit from the liquidity brought by a large number of users, decentralized lending services have the following three major advantages:

• Counterparty risk can be significantly reduced;
• Both lenders and borrowers can have full predictability regarding the use of funds;
• Loan interest rates and parameters are typically controlled by the user community rather than a central authority.

By building a fixed-rate lending market on Ethereum, Notional Finance combines the convenience and low-risk nature of fixed-rate loans with the accessibility, efficiency, and security of DeFi.

How Does Notional Finance Work?

The core of the Notional Finance protocol is its token fCash, each fCash token is defined by two factors:

• The associated cryptocurrency
• The maturity date

Users holding fCash tokens can redeem them for an equivalent amount of the associated cryptocurrency on or after the maturity date.

Lenders can deposit assets into the Notional Finance protocol, set a maturity date, and then receive fCash tokens associated with the value of the deposited assets. The number of fCash tokens initially received by lenders is proportional to the amount of crypto assets they deposited, meaning that as long as on the maturity date (or thereafter), lenders can redeem the fCash tokens they hold at a 1:1 ratio for the initially invested cryptocurrency, and they will also receive fixed interest income.

Borrowers can withdraw assets from the Notional Finance protocol, and they also need to set a maturity date. Unlike lenders, in exchange, they receive a negative balance of fCash, the size of which is proportional to the total amount that the borrower must pay at the fixed rate on the maturity date. In other words, on the maturity date, the fCash balance is essentially a basis for the borrower to provide an equivalent amount of the associated cryptocurrency in exchange for the negative balance of fCash at the specified maturity rate. Similar to lenders, the size of the negative fCash balance is proportional to the total amount the borrower must pay at maturity under the fixed rate. After the maturity date, the fCash balance essentially serves as the obligation for the borrower to provide an equivalent amount of the associated cryptocurrency.

Moreover, fCash tokens are always generated in pairs: one side is the asset (i.e., lender tokens), and the other side is the liability (i.e., borrower balance), which means that the net amount of assets and liabilities in the entire ecosystem is zero. This aligns with the traditional financial saying: where there is borrowing, there must be lending, and borrowing must equal lending.

Figure 2: Assets and liabilities in fCash

To facilitate the effective exchange of these fixed rates, as well as fCash tokens and the associated cryptocurrencies, the Notional Finance protocol uses several liquidity pools. Each liquidity pool holds fCash and its associated cryptocurrency, meaning that each liquidity pool corresponds to a specific cryptocurrency and a specific maturity date. The shares of fCash vs. the amount of cryptocurrency in the liquidity pool will change as the maturity date approaches, matching the rates corresponding to the fixed rate.

To manage these liquidity pools, Notional Finance uses its own automated market maker (AMM) and employs custom enhancements (such as dynamic curve sensitivity) to help stabilize interest rates and reduce slippage (the impact of deposits or withdrawals on the actual interest rate).

Potential Use Cases

Broadly speaking, Notional Finance has released many new lending use cases in the decentralized finance space, which have been well received by many users, especially those averse to risk and unwilling to take on long-term debt.

Potential use cases for exploring classic fixed-rate loans using the Notional Finance protocol in the decentralized finance space include:

Trading companies typically prefer fixed-rate borrowing over floating-rate borrowing because this model can fund more reliable and low-return trading strategies; although the expected return on fixed rates may be lower, high volatility in rates can put companies at risk and prevent them from ensuring profitability.

Traditional lending institutions usually prefer to borrow at fixed rates because these institutions also pay returns to customers at fixed rates. Floating-rate loans can harm these companies' profit margins and introduce significant risks into their business models.

Cryptocurrency holders in need of liquid assets may prefer to borrow cryptocurrency assets at fixed rates rather than directly selling their crypto assets and losing their positions. Fixed-rate lending products allow such holders to explore larger investment opportunities, as they can flexibly provide funding using their held cryptocurrencies, and the risks are much lower. Reportedly, some users have obtained fixed-rate loans directly from Notional Finance to pay off their entire mortgage.

DeFi projects in urgent need of liquidity may also seek fixed-rate loan products instead of engaging in liquidity mining. Through liquidity mining, DeFi projects must return substantial rewards to liquidity providers within a relatively short time frame, but the specific outcomes depend on whether the project can achieve success. Once issues arise, these rewards can become unsustainable, or even lead to total loss, while fixed-rate loans can guarantee project responsibilities and obligations over the long term.