Detailed Explanation of the Emerging Lending Protocol Euler: How to Enable Any Token to Be Listed and Layer the Risks?

Author: Chole, Chain Teahouse

Before the DeFi wave began in 2020, the main applications were still lending protocols—whether it was the veteran DeFi projects like Maker and Compound, which focused on mainstream coins and stablecoins, or the emerging Aave and Curve.

However, these lending platforms did not have non-mainstream tokens available for lending or borrowing, and users could not list any tokens at will but had to go through governance voting, so they were all waiting for the emergence of a permissionless model. Because there was still a demand for lending non-mainstream tokens, various tokens gradually accumulated, forming a huge demand that led to the emergence of the Euler protocol.

The open lending protocol Euler, developed by the Euler XYZ team, allows any token with a WETH trading pair on Uniswap V3 to be listed on the lending market, enhancing liquidity and reducing risk through a series of mechanisms.

In simple terms, any user can list any token on Euler for supply and borrowing.

1: Project Overview

Euler's biggest advantage is its permissionless listing mechanism, which helps users earn interest in the lending market without the need for a third party.

When lenders deposit liquidity into the Euler pool, they receive interest-bearing ERC20 eTokens (similar to Compound's collateral tokens, cTokens). As long as there are unborrowed tokens in the pool, they can redeem their share of the underlying assets in the pool at any time. Borrowers can withdraw liquidity from the pool when needed and must return the funds with interest.

Therefore, for borrowers, Euler injects a tokenized debt interest-bearing token, dToken, similar to the debt tokens in Aave, which is minted when borrowing funds and burned upon repayment.

Euler relies on Uniswap V3's decentralized time-weighted average price (TWAP) oracle to assess users' creditworthiness. When a borrower's risk-adjusted liability value exceeds the collateral value, liquidation may occur.

Allowing users to list tokens comes with higher risks, and Euler proposes a series of methods to manage risks to achieve the vision of a permissionless lending protocol.

2: Application Scenarios

Permissionless Listing Mechanism:

Euler allows users to decide which assets can be listed in the lending protocol. Users can add any asset with a WETH trading pair on Uniswap V3 to the Euler lending protocol. Through Euler's multi-tier asset classification mechanism, user asset risks can be reduced.

Asset Classification:

Since Euler accepts any token that has a trading pair with WETH on Uniswap V3, this permissionless feature also increases the lending market risk for each token. If the price of a token fluctuates too much and the liquidation process cannot fully repay the borrower's liabilities, it may cause problems in different asset pools.

To address such risks, Euler divides assets into several different tiers:

(1) Isolation-tier Assets:

Isolation-tier assets can be used for general lending but cannot be used as collateral to borrow other assets.

In simple terms, if a user uses USDC and DAI as collateral and wants to borrow an asset currently classified as isolation-tier, they cannot borrow another asset. This account can only independently lend the isolation-tier asset, and there are no restrictions on isolation-tier assets; any asset is preset as isolation-tier.

The benefit is that many small tokens can be lent on Euler as long as they have a trading pair on Uniswap V3, but they cannot be used as collateral. If this asset experiences significant volatility leading to liquidation, the nature of isolation-tier assets ensures that the liquidation will not affect other assets.

(2) Cross-tier Assets:

Cross-tier assets can be used for general lending and also cannot be used as collateral to borrow other assets.

However, unlike isolation-tier assets, cross-tier assets can be borrowed together with other assets. The cross-tier classification allows for more flexible use of collateral, but since different assets will affect each other during liquidation, the risk is higher than that of isolation-tier assets.

For example, if a user has USDC and DAI as collateral and wants to borrow cross-tier assets one and two, they can operate with the same account on Euler.

(3) Collateral-tier Assets:

Collateral-tier assets can be used for general lending and cross-lending and can also be used as collateral.

For example, USDC and DAI are collateral-tier assets, meaning they can be used as collateral to borrow other assets, whether it is LINK or UNI.

Reactive Interest Rates:

To avoid the need for each lending market to decide and adjust the most suitable parameters, Euler uses control theory to assist in adjusting lending rates. Specifically, Euler employs a PID controller, which amplifies the rate of change of borrowing rates when asset utilization exceeds the target level.

When asset utilization is below the target level, the rate of change of borrowing rates is suppressed, resulting in reactive interest rates that adjust according to market conditions of the underlying assets without the need for continuous governance to change parameters.

MEV-resistant Liquidation Mechanism:

Euler does not adopt a fixed percentage discount but allows the discount to gradually increase as the value of the position decreases, meaning the discount becomes higher over time, creating a unique trading style.

Therefore, potential liquidators need to decide whether to liquidate at the current discount percentage. Each liquidator will have different standards for how much profit they want to make, leading to liquidations at different points in time.

Euler utilizes the TWAP feature to ensure prices rise or fall smoothly, while the value of positions declines smoothly, transforming the liquidation discount into a gradually increasing discount that can partially suppress MEV occurrences.

Multi-collateral Stability Pools:

Euler allows lenders to support liquidations by providing liquidity to stability pools associated with each lending market. Liquidity providers in the stability pool earn interest by depositing eTokens while waiting for liquidations to be executed, preventing liquidity providers from attempting to control the system by moving assets in and out.

When a liquidation is processed, the liquidator uses the liquidity from the stability pool to cancel the borrower's debt and returns the discounted collateral to the stability pool (after deducting fees, the remainder belongs to the liquidator). Ultimately, liquidity providers in the stability pool will exchange their eTokens for the discounted index of the collateral assets. This method can be seen as an extension of the multi-collateral form of the stability pool concept pioneered by the Liquidity protocol.

Thus, the main advantage of using stability pools is that when the protocol deems a borrower to be in default, it can use internal liquidity to immediately handle the liquidation, and the liquidator does not need to acquire assets from a third-party exchange.

Using Internal Multi-collateral Stability Pools for Liquidation:

Euler draws on the stability pool model pioneered by the Liquity protocol and expands it into a multi-collateral stability pool format, allowing lenders to support liquidations by providing liquidity to the stability pools of each lending market. In other words, lenders can passively exchange their tokens for liquidation collateral assets during the liquidation period.

The advantage of this mechanism is that when the protocol determines that a borrower has reached the liquidation threshold, the liquidator can immediately liquidate using internal liquidity sources without needing to exchange assets from third-party exchanges, significantly reducing transaction costs.

Euler's interest rate model is similar to the dynamic interest rate model designed by the Delphi Digital team. When utilization exceeds (or falls below) the target utilization level, a PID controller is used to amplify (or suppress) the rate of change of interest rates. In simple terms, it utilizes reactive interest rates that adapt in real-time to the market conditions of the underlying assets, effectively improving capital efficiency.

According to the Euler white paper, platform interest rates may even undergo second-level compounding calculations.

3: Token Model

The token $EUL plans to be distributed according to 100,000 block epoch cycles.

In the epoch 1 phase, borrowers from different lending markets such as USDC and WETH will proportionally distribute 36,915.69 EUL tokens based on their time-weighted borrowing amounts.

4: Investment Institutions

Euler raised $8 million in Series A funding led by Paradigm in August 2021, with other participants including Lemniscap and individual investors from well-known blockchain projects, such as founders and CEOs from The Daily Gwei, Bankless, Synthetix, Coinbase, Product Hunt, and others.

5: Team Introduction

Euler is an open lending protocol developed by the Euler XYZ team, with three co-founders (from left to right).

Euler CEO Michael Bentley is a biologist at the University of Oxford in the UK, while the other two co-founders are Doug Hoyte and Jack Prior, who currently serve as developers for the Euler XYZ team. The team's advisor, Mick de Graaf, is a co-founder of the Ethereum decentralized asset management platform DEFIED.io and has also served as a developer at the blockchain fund PieDAO.

6: Community Situation

Twitter:

https://twitter.com/eulerfinance

16k followers

Discord:

https://discord.com/invite/CdG97VSYGk

9,297 members

Telegram:

https://t.me/eulerfinance_official

3,521 followers

7: Chain Teahouse Review

Euler aims to achieve an open market for free lending without permission through various methods—from the perspectives of both borrowers and liquidators, satisfying the needs of different roles through permissionless listing mechanisms, optimized liquidation mechanisms, and replacing collateral transactions with multi-collateral stability pools, allowing lenders to ultimately passively exchange their tokens for liquidation collateral assets.

The improvements developed by the Euler XYZ team align with the goals of decentralization, but whether the measures currently taken can effectively manage risks will require further validation over time and gradual improvements from the team to draw conclusions.