Four Innovative Experiments in DeFi Lending

This article is from Glassnode, authored by Luke Posey, and translated by Hu Tao.

Lending is one of the most important cornerstones of the DeFi ecosystem. Projects like Aave, Compound, and Maker have long been dominant, but many innovative lending projects have also emerged to meet the diverse needs of DeFi users.

Glassnode researcher Luke Posey has detailed the recent innovative experiments in the DeFi lending market, including products like Alchemix, Cream Finance, Rari Capital, and Liquity, which are of great reading value for DeFi users. For some time, lending projects have been leading in total liquidity compared to blue-chip DeFi projects, while Aave and Compound still dominate the field. In less than 24 months, their growth has increased the total value of locked collateral from $100 million to over $15 billion. This is driven by a proven multi-asset over-collateralized lending formula.

A few months ago, Aave's total deposits surpassed Compound, partly due to its liquidity mining incentives and the addition of extra collateral options, stable rates, and other features. As of June, the total borrowing on Aave has also overtaken Compound, now dominating both deposits and outstanding loans.

We can attribute part of Aave's success to its willingness to innovate and align incentives with users. That is to say, it is difficult to experiment with proven real protocols.

For markets the size of Aave or Compound, the motivation to try new ideas that could put over $1 billion in collateral at risk is limited. Instead, we can look to younger projects and starry communities for new perspectives on how lending market innovations can benefit DeFi participants.

In this article, we will explore four young projects, each with a market cap of less than $300 million, all of which are less than 10 months old, with some even only 3 months old.

1. Alchemix's Auto-Repaying Loans

Alchemix has gained attention for its unique future yield program. DAI can be deposited as collateral, and users can borrow alUSD against it. Depositors can borrow up to 50% of their collateral as alUSD. Their debt is automatically repaid by the yields generated from Yearn Finance.

The DAI deposited by users is sent to the Yearn Finance yvDAI vault to earn yields. They do not pay interest on the loan; instead, their debt is automatically repaid through the yields generated from the DAI deposited in Yearn. Additionally, the yields from the "transmuter" enhance returns; the "transmuter" is a mechanism that supports the protocol and serves as the main mechanism for anchoring the protocol's synthetic tokens.

It is important to note that in this setup, users' collateral cannot be liquidated by external forces, as the user's debt will only decrease over time as the protocol earns yields from the Yearn yvDAI vault. The obvious risk here is that if the Yearn yvDAI yield approaches 0%, then theoretically the loan will never be repaid. If rates become lower, users can still manually repay their debts.

Alchemix currently accounts for over $260 million of the DAI currently deposited in Yearn Finance, with $150 million of alUSD in the transmuter, converting to DAI and increasing rewards through additional Yearn deposits. Additional TVL in the Alchemix ecosystem exists in liquidity incentives and single-sided reward mechanisms.

alUSD can be used like any other stablecoin in the DeFi ecosystem. It is commonly used in the alUSD pool on Curve + Convex or in single-sided alUSD farms on Alchemix. There are incentives in the alUSD pool on Curve to encourage more liquidity to swap alUSD into other stablecoin pairs.

Additionally, Alchemix has set up farms to incentivize liquidity in the ETH/ALCX pair for trading governance tokens on Sushiswap.

Current returns for each fund pool are as follows:

• alUSD3CRV Pool: 30% APR

• ETH/ALCX Pool: 170% APR (Note this is the Miner Pool 2 farm, meaning farmers need to engage with ALCX, the native governance token; this pool has high risk of permanent loss if the prices of ETH and ALCX diverge.)

• Single-sided ALCX Pool: 140% APR

• Single-sided alUSD Pool: 30% APR (to be discontinued)

The ETH/ALCX miner pool is set to migrate to the new Sushiswap Masterchefv2 contract in the coming days. This new contract from the Sushiswap team implements multi-reward liquidity incentives, meaning that this fund pool will reward users who stake both the governance token ALCX and SUSHI tokens.

As Alchemix matures, many experimental features and advancements of the protocol can be explored. Upcoming features include alETH and alBTC, adding more forms of collateral to the protocol. Additional collateral is attractive for users who prefer to hold these assets rather than stablecoins. Risk collateral has proven successful in Aave and Compound.

In Compound, ETH is the largest source of collateral, while in Aave, ETH ranks second. Once ETH deposits are enabled, Alchemix collateral is likely to surge. Additional synthetic assets are also appealing to token holders looking to access various lending sources through Alchemix.

2. Cream Finance Loans and Iron Bank's Collateralized Loans

Cream is the earliest protocol launched on our list, debuting last August. The protocol has slowly found its place in the ecosystem, partnering with Yearn to become the preferred lending protocol within the Yearn ecosystem. With the maturity of Aave and Compound, normal lending behavior is to find the best rates and deepest liquidity in these markets. Cream's wide array of assets makes it a common third option for niche borrowers when necessary.

Cream currently supports 78 different assets of varying sizes and volatilities, but its market size is significantly smaller than its competitors. Large depositors can easily scale the collateral pool to lower loan annual interest rates, and similarly, they can withdraw in bulk and raise rates. The end result is that the rates offered by Cream are often higher and more volatile compared to larger lending markets.

Note that despite a TVL of $1 billion, Cream has a relatively small user base (around 9,000), but such a low user count is not unique in DeFi protocols. In contrast, Aave has only about 40,000 unique addresses that have interacted with the protocol.

Cream's most recent major innovation is its focus on protocol-to-protocol unsecured lending, which may make excessive focus on user numbers less important. Instead, both depositors and borrowers are given greater weight, whether in terms of reputation or scale. Cream sets credit limits for zero-collateral borrowers on its address whitelist, which includes trusted protocols like Yearn and Alpha Finance.

This is a significant innovation as it allows protocols to borrow assets without wasting their own liquidity as collateral. As a result, Iron Bank products currently hold $770 million in collateral.

Savvy farmers can rotate their assets across many high APY markets. Here are some sample APYs from pools with healthy liquidity in Iron Bank and Cream:

• DAI, USDC: Iron Bank base APY around 6%, CREAM around 10%

• wBTC: Iron Bank base APY around 7%, CREAM around 1.4%

Over time, multiple protocols with similar under-collateralized credit lending characteristics to Iron Bank have emerged in the market. Ideas are being explored and implemented to link credit to bank accounts (Teller), through identity and social media accounts (not announced), and through purely governance-driven voting (TrueFi), with some success.

3. Rari Capital's Multi-Asset Lending Pools in the Fuse Rate Protocol

Rari Capital has recently gained more attention due to a $15 million smart contract exploit stemming from a recent integration bug with Alpha Finance. $15 million worth of ETH was taken.

After the exploit was attacked, we can judge the quality of the response to the turmoil as investors. Protocols that respond effectively to turmoil tend to gain more community trust and cohesion. Those that cannot respond effectively often struggle to recover from the pressure.

Fuse's deposit peak reached about $50 million in May, dropping to $26 million during the exploit attack and subsequent market downturn. Since then, deposits have rebounded to $37 million.

Despite the turmoil, Rari Capital has shown some resilience with its experimental and innovative pace. Their unique lending pools allow for the creation of any asset combination. This creates a unique market structure, unlike Aave and Compound, where all collateral options are linked to all borrowing options in isolated pools.

In Fuse, these individual fund pools are set up to isolate assets, allowing for separated risks and returns, whereas in Aave/Compound, any added assets bring more or less risk to every lender/borrower on the platform. Through isolated asset pools, assets in each pool only share risk within that pool, separate from the rest of the platform.

The scale and higher risks of these nascent markets allow cautious farming to enhance yields. The interest rates are similar to those in Aave/Compound, and while larger lenders may not be interested at present, smaller farmers whose positions do not significantly impact liquidity can profitably enter and exit these markets without affecting yields. Fortunately, these entries and exits only affect individual fund pools.

High utilization of niche assets in Fuse is not uncommon. Here are some yield rates from Rari Capital's largest Fuse pools.

• ALCX: 25% supply rate APY

• USDC: 23% supply rate APY

• DAI: 12% supply rate APY

4. Interest-Free, Efficient Collateralization with Liquity

Liquity builds on much of MakerDAO's innovation while making unique experimental changes. Like MakerDAO, Liquity manages the issuance of ETH-backed stablecoins, which they call "troves," functioning similarly to Maker's CDP.

Some key changes from MakerDAO to Liquity include:

• Governance token -> Zero governance

• Different collateral, relying on USDC -> ETH-only collateral

• Interest controls issuance -> Redemption controls issuance

• MKR burning to increase value -> Single-sided LQTY collateral for rewards

Liquity achieves interest-free lending and stability by charging a one-time borrowing and redemption fee priced algorithmically and liquidating troves at 110% collateralization. In contrast, MakerDAO uses interest rates to encourage/discourage borrowers. By charging borrowing and redemption fees in Liquity, lenders and collateral holders are incentivized by this potential profit, allowing borrowers to calculate fees in advance without worrying about interest rate fluctuations. LUSD is paid upon borrowing, while ETH is paid upon redemption.

LUSD issued from a trove at a minimum collateralization rate of 110% can be deposited into the stability pool, earning about 36% APR in LQTY token rewards. LQTY can currently earn up to 134% APR through staking LQTY.

Note that the LQTY collateral reward rate of 134% APR is a highly variable 7-day rate. During periods of high redemption rates, this reward can be very high, while at other times, it may be much lower.

5. Understanding Protocol Risks

We note that while high returns across all mentioned protocols are attractive, risks also increase accordingly. The high returns expected by farmers holding newly minted governance tokens from failed projects will become meaningless, while those from long-standing projects are more likely to retain their value.

Additionally, as more tokens are minted, the high inflation of token supply can easily lower prices over time as more supply circulates. Farmers should strive to understand whether their returns lag behind, keep pace with, or exceed token inflation. If interest rates seem too good to be true, then one of two things is almost certainly true: you have truly found alpha, or the risks have significantly increased.

Unlocking timelines may vary by project. Currently, ALCX's supply increases by about 43% monthly. If holders engage with ALCX in their strategies, their goal may be to outpace inflation. If they believe in the long-term value of the governance token, then this may be less urgent for their strategy.

Liquity's supply follows a 32,000,000 * (1--0.5^year) annual inflation plan. This means that approximately 16 million LQTY is released each year. This 12-month period will mark an inflation rate of about 3.3 times the current circulating supply. Rari's governance token plays a smaller role in the ecosystem. Within 60 days, it sends 12.5% to the team, with the remainder sent to protocol users. Unlocking timelines vary widely, and you need to understand how any tokens you hold will be revalued over time.

Depending on your risk tolerance, your chosen strategy will adapt to the token's inflation. Ideally, you want to keep risks to a minimum while doing your best to outpace inflation. Additionally, you want enough buyers/holders to see some value support for holding the token.

High inflation without sellers can create a strong market, while high turnover with high inflation leads to price charts with negative slopes. Token attributes like protocol revenue and value accumulation mechanisms for other token holders can incentivize token purchases and holding.

Liquidity mining often involves rewards in the form of governance tokens, but their value is usually unrelated to anything. Even those tokens that reward holders with protocol revenue typically provide only meager income. The depreciation of these tokens' value is often severe and persistent, as farmers can quickly sell their rewards. We have seen token inflation rates in DeFi exceed 100,000% annually. People should strive to understand the inflation timeline and any other associated risks.

New lending protocols have been continuously released over the past year, with varying degrees of experimentation and innovation. They have emerging markets with highly incentivized returns, higher risks, and ample space to adjust through small user bases and closely-knit, highly engaged communities. The larger the protocol and market size, the less malleable and easily adjustable it becomes. Some of the best returns often come from communities that actively engage with emerging projects, making it very important to understand the quality of the team and community.