The fixed-rate agreement Element Finance has been launched on the mainnet. How does it work specifically?
This article is from the official website of the well-known investment institution Placeholder, authored by the institution's partner Joel Monegro, and translated by Chain Catcher.
Today, the mainnet of the fixed-rate lending protocol Element Finance officially launched, becoming another important player in the DeFi fixed-rate market. Previously, the project attracted significant attention due to investments from several well-known investment institutions and industry insiders.
In April of this year, Element Finance raised $4.4 million in a round led by a16z and Placeholder, with participation from industry figures such as Ethereum co-founder and ConsenSys founder Joseph Lubin, Balancer co-founder Fernando Martinelli, Aave founder Stani Kulechov, and Compound founder Robert Leshner.
So, how exactly does Element Finance operate? What problems is it trying to solve? Recently, the project's investor Placeholder wrote a detailed introduction, so Chain Catcher has compiled this article to help everyone better understand the project. Here is the main text:
Yield is one of the most important fundamental elements in financial markets. Besides returns, it also reflects investment profits. However, if the returns stem from changes in asset prices—and are only realized upon the sale of the asset—yield serves as a measure of the cash flow generated and distributed to asset holders. While they are different phenomena, yield determines asset prices, and vice versa. Element is a protocol that allows developers and investors to harness the power of yield in their applications and strategies.
For example, you can profit from an investment in a company's stock by selling it at a higher price (yield) or when the company distributes excess profits in the form of dividends (yield). You can then value the stock based on its cash flow, which is common in securities analysis. Similarly, the interest rate paid by borrowers in a loan agreement is the yield earned by lenders, while the market value of that agreement is a function of its expected yield. Yield is expressed as a percentage: cash flow divided by the size of the relevant investment (for example, a $100,000 investment generating $5,000 in cash flow annually has a yield of 5%).
Yield is a way many DeFi protocols reward active participants. For instance, decentralized exchanges like 0x, Uniswap, and Balancer compensate market makers and liquidity providers with income from trading fees. Lending markets like Aave and Compound pay lenders most of the interest that borrowers pay, while "robo-advisors" like Yearn maximize yield across various underlying strategies. You can also earn yield from proof-of-stake systems like ETH2 or Decred.
When you stake assets in most DeFi protocols, you receive redeemable tokens that can be used to exchange your initial deposit and any yield generated during your staking period. In Aave, these are "a-tokens," in Compound they are "c-tokens," and in most AMM DEXs, they are referred to as "LP" tokens. However, these come with capital efficiency issues. First, yields are often market-based, making them variable and frequently volatile, so you cannot determine the final value until redemption. Second, your deposits are locked during the staking period. They remain yours, but you cannot use them elsewhere during the deposit period.
For example, if you invest 10,000 USDC in Aave, the current annual yield (as of the time of writing) is about 8.92%, but you cannot know whether you will earn more or less in the next three to six months. When your principal (the 10,000 USDC deposit) is staked in the protocol, you cannot use the principal, which prevents you from leveraging those funds elsewhere.
Element addresses these two issues as a layer on top of yield farming protocols. It works by splitting the principal and staking yield into two separate tradable tokens: principal tokens and interest tokens. At the end of a set term (for example, 3 or 6 months), each of your principal tokens can be redeemed for a corresponding share of the initial staked principal, while your interest tokens can be redeemed for the yield generated by the principal during the same period.
For example, if you execute a 10,000 USDC Aave strategy through Element over a 12-month term, you will receive 10,000 redeemable principal tokens for 10,000 USDC, as well as 10,000 redeemable interest tokens for the yield generated during that year, regardless of how much interest Aave generates that year. If the average interest rate is 10%, the final value of the interest tokens would be approximately 1,000 USDC.
This is a powerful feature. By separating yield from principal, you can do several things:
First, your principal is now liquid. Continuing with our example, your 10,000 USDC is still locked in Aave for a year, but you now have an equivalent amount of principal tokens that you can sell at a discount to address the lock-up issue. The market may be interested in buying your 10,000 USDC principal tokens for 9,400 USDC, thus ensuring a fixed yield of 6%. This new approach addresses the uncertainty of yield in yield farming protocols.
Principal tokens trade at market discounts similar to zero-coupon bonds, unlocking a new asset class in DeFi. Many investors will gravitate toward fixed-income instruments, creating demand for principal tokens, while their sellers can retain most of the principal. This naturally appreciates the asset, providing stable interest exposure as an alternative to the mortgage market, which may require constant liquidity. If you hold the underlying asset long-term, this is also an effective way to acquire them at market discount prices, further enhancing your expected returns.
Liquid interest tokens also provide you with high flexibility. You can sell principal tokens and hold interest tokens, or sell interest tokens and hold principal tokens, gaining some yield today for tomorrow. Or sell both! New markets and compounding strategies will inevitably emerge (for example, you can re-stake your principal for leveraged yield).
Element also makes it easier to switch yield strategies. For instance, if you want to move 10,000 USDC from Aave to Curve, instead of un-staking from Aave and re-staking in Curve, you can simply trade your principal or interest tokens from one strategy to another through a decentralized exchange, saving time and money.
What interests me most is what will happen once markets form around these new DeFi primitives. Just as every investor in the world pays attention to the national bond market and interest rates, DeFi investors can gather valuable information from the principal and interest token markets. Higher or lower fixed yields on principal tokens provide certain types of information, as do higher or lower prices for variable interest tokens.
A higher discount on principal tokens may indicate that investors expect higher risk-adjusted returns in the broader market, but it may also signal higher principal risk in the underlying strategy. In lending protocols like Aave or Compound, a rise in the price of interest tokens for USDC deposits may indicate that the market expects interest rates to rise, while a drop in the price of interest tokens for LP equity in AMM DEXs may suggest that the market anticipates a decline in trading volume and fees.
In principle, improving capital efficiency is key to scaling the DeFi market to the next order of magnitude, as it helps attract increasingly larger pools of capital.