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Eigen Finance: Hedging Defi Interest Rate Risks

Eigen Finance: Hedging Defi Interest Rate Risks

Project Description

Lending is the largest pillar of Defi, many protocols on Solana provide variable interest rate borrowing and lending solutions. However, the current floating rate market is undesirable since it is hard to predict the interest rate change thus hard to plan accordingly especially for larger institutions. There are a total of 128 Trillion loans in the traditional financial market and the bulk of it is in terms of fixed rate lending, including government bonds, company bonds, etc. Compared to crypto, we have only 37 Billion in all the borrowing and lending protocol combined while the bulk of it is floating rate debt (less than 1 Billion between Notional, Element and Yield v.s. Over 20 Billion combining Compound and Aave). If the traditional financial market is of a reference, then we should see a growing number of fixed rate lending protocols emerge in the coming years. Broadly speaking, there are 4 different types of fixed rate implementation in the markets: Zero Coupon Bond: Notional Yield Yield Stripping: Element Stable Rates: Aave Stable Rates Structure Products: Barnbridge However, each has issues of their own. Zero coupon bonds, for example, require building up new pools that are separate from Compound and Aave which causes fragmentation of liquidity. Furthermore, they need their own set of liquidation engines and risk parameters completely separate from the more established floating rate lending protocols such as Solend, Port, Larix and Jet. Yield stripping is another mechanism that allows for fixed rate lending. The largest downside is that it doesn’t allow for fixed rate borrowing which is a common demand among trading firms. Also the introduction of two tokens: principal and yield tokens requires separate AMM pools for principal tokens and underlying tokens and yield tokens and underlying tokens. This further fragments the liquidity. Stable Rate is proposed by Aave, however the rate is just an average of the previous interest rate and it is subject to change at rebalance which is hard to qualify as real fixed rate. Structured products such as Barnbridge separates the position into junior bond and senior bond. The senior bond holders can receive fixed interest. However, this mechanism also only enables fixed rate lending but not borrowing. Here we have built a new mechanism which have the following advantages: Allow for both fixed rate lending and borrowing Doesn’t fragments liquidity Allow for speculators to both long and short the defi interest rate Two tokens are issued to represent users' long and short positions. Users generate Long and Short tokens by depositing margin into the protocol. By trading Long and Short tokens, users can hedge, speculate on the existing defi interest rate in lending markets such as Solend, Jet or Port Finance.. The Long and Short tokens are settled in the following rules: Long: settled to the interest rate change between the term start date and the end date of the underlying defi borrowing & lending protocols. Concretely the value is: interest earned * leverage. The highest settlement value is capped at 1. Short: settle to 1 - Long. We have also integrated with an internal AMM for swapping between Long and Short tokens. And we deliberately make the swap between Long and Short tokens instead of two separate pools that are between Long and underlying tokens and Short and underlying tokens. To borrow at a fixed rate users just needs to borrow at existing lending protocols, and use a small amount of capital to hedge their interest rate changes by purchasing Long tokens in the internal AMMs. Suppose Alice has borrowed 10,000 USDC in an underlying floating rate borrowing protocol. At the term start, the Long token for the pool is selling at 0.4 for 10X leverage. She obtains a fixed rate loan of 4% APY We can analyze two scenarios in turn. First scenario is that the actual borrow rate is higher than 4% and the second scenario is that the borrow rate is lower than 4%. Suppose the underlying borrow rate is 8%: then what Alice is paying for is: 800 (floating interest) + 800 (Long settled amount) - 400 (Long token cost) = - 400. She is paying 400 / 10,000 = 4% interest. Suppose the underlying floating rate is 3%, -300 (floating interest) + 300 (Long settled amount) - 400 (Long token cost) = - 400. She is still paying for 400 / 10,000 = 4% interest. To conclude, we feel that the adoption of fixed rate lending will drive the next wave of adoption for Defi. And we believe that the new mechanism outlined above will become an integral part of it due to its capital efficiency and allowing for both borrowing and lending.

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