DeFi Project Spotlight: Euler Finance, the Next-Generation Money Market

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 belongings. It’s designed to maximise capital effectivity and decrease 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 belongings.

To know Euler’s distinctive worth proposition, it’s price exploring DeFi’s present lending panorama. Right now, the 2 dominant decentralized lending protocols are Aave and Compound. Collectively, they seize about 50% of the overall market share, respectively holding about $6.06 billion and $2.79 billion in total value locked. Customers seeking to earn curiosity on their crypto belongings can deposit them into Aave or Compound’s liquidity swimming pools to make them out there for borrowing. Then again, customers seeking to brief crypto belongings 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 belongings. The tokens out there 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 belongings. As an alternative, each protocols depend on a permissioned itemizing system whereby any new tokens aspiring to get listed should first be authorised by governance by means of 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 will be listed and made out there for borrowing and lending. 

Crypto Briefing related with Euler Finance co-founder and CEO Michael Bentley to be taught in regards to the protocol, and he started by highlighting the protocol’s assist of riskier belongings. “Euler was designed with plenty of improvements to extend capital effectivity and scale back danger. Specifically, 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 assist 74 belongings. It at present holds round $200 million in whole worth locked. 

Whereas permissionless markets actually profit the business, it’s price underscoring that in addition they introduce a myriad of dangers. Therefore, Euler needed to contemplate all the perils and innovate in the course of 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 variety of progressive options.

One among its key options is an asset classification system. It goals to mitigate the potential spillover impression liquidations may trigger by classifying belongings based on their danger profiles. Belongings are divided into three tiers: isolation-tier, cross-tier, and collateral-tier. Isolation-tier belongings can’t be used as collateral, nor can they be borrowed from the identical account alongside some other belongings. Cross-tier belongings, which fall extra on the left-hand aspect of the chance curve, can’t be used for collateral, however they are often borrowed alongside different cross and collateral-tier belongings. Lastly, collateral-tier belongings are the one belongings that can be utilized as collateral.

By isolating the riskiest belongings and limiting 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 may spill over to a different and go away the protocol with unhealthy debt. Because of this, their itemizing necessities are a lot stricter. 

When belongings are first listed on Euler, they’re categorised as isolation-tier. Their tier will 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 Worth (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 predominant advantages: Uniswap’s TWAP is on-chain, which means it doesn’t require centralized intervention at any time when a brand new lending market is created on Euler. Secondly, executing financial assaults on lending markets leveraging Uniswap’s TWAP oracle is capital-intensive, which means the protocol is extra immune to potential exploits involving worth manipulations than different centralized options.

Commenting on this design selection, Bentley stated that it was important if Euler was ever going to realize its objective. “Whereas Compound and Aave act as gatekeepers over what belongings customers can lend or borrow as a result of they rely upon centralized oracles like Chainlink, we constructed on high of Uniswap,” he stated. “You want a decentralized worth oracle in case you’re ever going to have the ability to supply permissionless lending and borrowing.“

One other characteristic that makes Euler distinctive amongst lending protocols is its implementation of reactive rates of interest, which remedy the issue of manually figuring out the right parameters for each lending market. “We pioneered reactive rates of interest that just a few 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 scorching, it turns up the air conditioning. Equally, reactive rates of interest purpose to stabilize the utilization ratio of swimming pools and subsequently improve the capital effectivity of the protocol as a result of lenders get a greater worth for cash on Euler than elsewhere.”

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 degree. In easy phrases, as an alternative of utilizing static fashions that regulate a particular lending market’s rates of interest primarily based on the availability and demand for capital based on 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.

Danger-Adjusted Borrowing Capability

Moreover the collateral components that decide borrowing capability primarily based on the chance profile of the belongings, Euler has carried out a two-sided strategy that additionally considers the chance profile of the borrowed belongings or liabilities to mitigate the dangers related to the permissionless borrowing and lending of long-tail crypto belongings. Explaining this characteristic, Bentley stated:

“We’re extraordinarily capital environment friendly in methods I believe Compound and Aave aren’t. We’ve got one thing known as borrow components, which allow the quantity of borrowing energy a person has to rely upon 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 chance issue of the borrowed belongings.”

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 components that decide the quantity customers can borrow primarily based on the chance profile of the belongings they’re pledging as collateral. When the loan-to-value ratio drops past a sure threshold and begins approaching some extent 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 person needs to pledge $1,000 price of ETH as collateral to borrow wBTC, when the collateral issue for ETH is about (by governance) at 0.7, the person can solely borrow $700 price 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 method may match effectively on the subject of borrowing safer tokens, it doesn’t account for the chance of borrowing extra obscure, riskier tokens. In response, Euler has carried out a two-sided strategy that introduces borrow components along with collateral components. 

On Euler, if a person has $1,000 price of USDC, a secure asset with a excessive collateral issue of 0.9, and needs to borrow ETH, a extra risky asset with a decrease borrow issue of 0.7, the person may borrow as much as $630 price of ETH. The quantity is calculated by multiplying the USDC collateral by the 2 borrowing components ($1,000 x 0.9 x 0.7). On Compound, which doesn’t account for the chance issue of the borrowed asset, a person may borrow $900 price of ETH ($1,000 x 0.9), placing their place at the next danger of liquidation. For belongings additional to the proper on the chance curve, Euler has even decrease borrow components. 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 set percentage-based low cost, as Aave and Compound do, Euler runs Dutch public sale liquidations, that are far much less punitive for debtors and in addition get rid of gasoline wars between would-be liquidators. 

Aave and Compound supply a set 5 to 10% low cost for liquidations, so when the person’s collateral breaks previous the liquidation worth, these hoping to liquidate the collateral rush in on the identical time to seize the premium. This results in precedence gasoline auctions as a part of DeFi’s so-called MEV wars, which produces adverse externalities for the broader ecosystem. 

Furthermore, mounted reductions will be extreme for giant debtors that suffer a liquidation, doubtlessly discouraging them from ever utilizing the protocols sooner or later. On the identical time, they could even be too small to incentivize smaller liquidations, doubtlessly 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 totally different liquidators have totally different danger and reward expectations, they theoretically choose totally different occasions to liquidate, circumventing any have to wage gasoline 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 turn into 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 person expertise. These embrace protected collateral, deferred liquidity checks, fee-free flash loans, an in-house transaction builder, sub-accounts, and environment friendly leverage.

Not like different lending protocols, Euler implements a particular deposit class known as protected collateral, which lets customers deposit belongings with out instantly making them out there 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 belongings like MKR or different governance tokens, folks don’t deposit them on cash markets as a result of they’re nervous folks 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 fashion, we are able to 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 control the MakerDAO’s governance.”

Deferred liquidity checks, however, let customers execute advanced place administration with out being constrained by inflexible collateral situations. The place different lending protocols examine an account’s liquidity at first of an operation, Euler customers can instruct the protocol to examine 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, benefit from arbitrage alternatives throughout DeFi, rebalance positions, execute advanced trades, and so forth.

Euler has additionally constructed a transaction builder contained in the person interface that enables customers to batch transactions and submit them to avoid wasting on gasoline charges. As well as, the protocol implements a intelligent approach to simplify taking up 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 operate to conduct all of their actions in a single transaction. The mint operate creates an equal quantity of deposits and money owed for an account, permitting customers to lever up in a single transaction by way of self-collateralized loans.

Last Ideas

In a sea of forks and copycat protocols, Euler is likely one of the uncommon youthful DeFi tasks that really 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 belongings—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 price noting that Euler isn’t essentially a superior product to earlier lending protocols. Quite, it’s a unique one which fills a niche 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.