Original author: Yilan, LD Capital

introduction

In-depth exploration of the new lending module launched by Thorchain on August 22, we found the shadow of Terra LUNA. The similarity with LUNA is mainly reflected in the fact that the collateral deposited by users is exchanged for RUNE. In fact, the rise and fall of the exchange rate of RUNE-collateral determines the inflation and deflation of RUNE, that is, RUNE absorbs the volatility of the RUNE-collateral exchange rate through inflation and deflation, just like LUNA absorbs the volatility of UST, but the two are different in their forms of expression (RUNE participates in lending, and is destroyed and minted when opening and closing loan positions, and LUNA participates in stablecoin anchoring, and is destroyed and minted by arbitrageurs when UST is unpegged) and the risk volume behind them (LUNA is minted without an upper limit, RUNE has an inflation and deflation upper limit, and only 50% of the collateral of synthetic assets is RUNE). In addition, the lending agreement has strict risk control and risk isolation measures, so the overall risk is relatively small, and will not generate systemic risks similar to Terra LUNA. Even if a negative spiral occurs, it will not affect other functions of Thorchain.

1. Understanding the Thorchain lending mechanism

The characteristics of Thorchain lending are that there is no interest, no liquidation risk, and no time limit (in the initial period, the shortest loan period is 30 days). For users, it is essentially shorting USD and long BTC/ETH collateral assets; for the protocol, it is essentially shorting BTC/ETH and long USD. The debt is denominated in TOR (Thornchain's USD equivalent), so users are similar to gold-backed options to buy BTC OTM calls, and the holders of the protocol/RUNE are the counterparties.

Opening a new loan will have a deflationary effect on $RUNE assets, while closing a loan will have an inflationary effect on $RUNE assets. BTC collateral will first be converted to RUNE, then destroyed, and finally the assets required for RUNE redemption will be minted. In this process, the difference between the collateral value and the debt, minus the handling fee, corresponds to the net destruction value of RUNE.

If the collateral increases when repaying, then when the RUNE price remains unchanged, more RUNE needs to be minted to redeem the required assets, which will cause inflation; if the price of RUNE increases, then it is ideal not to need to mint so many RUNE, and if the price of RUNE falls, inflation will be more serious. If the collateral falls when repaying, and the RUNE price remains unchanged, users may choose not to repay (no minting).

If the value of RUNE relative to $BTC remains constant between when a loan is opened and closed, then $RUNE will have no net inflationary effect (the amount destroyed is the same as the amount minted minted minus exchange fees). However, if the value of the collateral asset relative to RUNE increases between when a loan is opened and closed, then $RUNE supply will have a net inflationary effect.

To address inflation, lending controls are in place - there is also a circuit breaker design if minting causes total supply to exceed 5 million RUNE. In this case, the reserve will step in to redeem loans (not further minting), the entire lending system will be stopped and retired, but other aspects of THORChain will continue to operate normally.

Therefore, the entire lending process has a greater impact on RUNE's inflation and deflation, but when the overall lending cap is low, both inflation and deflation have upper limits. When the RUNE-collateral exchange rate rises indefinitely, the maximum opening volume with the maximum deflation is currently 15mln*0.33 (0.33 is the lending lever, which might change), i.e. 4.95mln (may increase in the future). When the RUNE-collateral exchange rate falls indefinitely, inflation is also controlled within 5mln by the circuit breaker.

Specifically, if the user overcollateralizes 200% of the collateral to borrow 50% of the required assets, the other 50% will be minted at the exchange rate of RUNE-collateral when redeemed. This step is essentially similar to LUNA, but under the mechanism of Thorchain Lending, since the Rune back part is only 50%, the product capacity is also small, so the overall risk is relatively small, and it will not generate systemic risks similar to Terra LUNA. This part of the risk is isolated, and even if a negative spiral occurs, it will not affect other functions of Thorchain.

1. How to understand the design of lending? For users, it is similar to a long option with a deep out-of-the-money and resettable strike price.

When Alice gives 1 BTC, she also gets 50% cash (in the case of a CR of 200%) and the opportunity to buy 1 BTC with this cash.

If BTC rises when repaying (assuming one month later), Alice repays the debt (that is, the value of BTC equivalent to 50% of one month ago), and uses the BTC price one month ago to buy this BTC. If it falls a lot, more than 50%, Alice chooses not to repay, the protocol will not generate inflation caused by mint rune (for Alice, her long position fails).

2. How to understand the absence of loan interest

It can be seen as users paying multiple swap fees instead of interest rates, which is essentially a CDP product. If loan interest is charged, this product will be less attractive to users.

The entire lending process is as follows:

Users deposit collateral of native assets (BTC, ETH, BNB, ATOM, AVAX, LTC, BCH, DOGE). In the initial stage, collateral is limited to BTC and ETH. The amount of collateral that each debt position can accept (debt position upper limit) is determined by the hard cap (15mln), Lending lever, and pool depth coefficient. Excess collateral generates debt, and the proportion of debt that can be obtained is determined by CR.

Borrowing: Alice deposits 1 BTC, which will first be exchanged for RUNE in the BTC-RUNE swap pool. These RUNE enter a V BTC pool and are destroyed and converted into a derivative asset Thor.BTC. The collateral of the synthetic asset is constant product liquidity, which is always 50% of the asset, and the remaining 50% is RUNE. Then the derivative asset Thor.BTC is sent to an Internal module, where there is a dynamic CR (collateral ratio) to determine how much loan can be obtained, and Thor.Tor (similar to USD) tokens are generated as a means of accounting for the loan. The steps that occur here are entirely for internal accounting purposes, and then a USDT loan is generated and given to Alice.

Repaying the loan: When Alice repays the loan, she sends all USDT or other Thorchain-supported assets to the protocol and converts them into RUNE. RUNE will mint Tor. The protocol checks whether the user has repaid all Tor-denominated loans. If all are repaid, the collateral will be released and converted into derived collateral (Thor.BTC). This derived asset will then be minted back into RUNE and swapped back to L1 BTC. RUNE is minted in this process.

It should be noted that these swap and convert processes will incur fees (one loan will incur at least 4 swap fees), so the total repayment amount needs to be more than the actual amount to pay these swap fees. Although there is no interest, the collection of multiple fees can actually be regarded as a substitute for interest. Although the wear and tear is huge, the RUNE fees generated are destroyed, which is a real deflation.

3. How to understand no liquidation and no repayment time limit

Since the debt denominated in TOR stablecoin is fixed, in fact, although the borrower can choose any asset to repay the loan, it will actually be converted into RUNE through the market, and liquidity providers and depositors will not lend their assets directly to borrowers. The pool is just a medium for exchange between collateral and debt. The whole process is a bet, which is why there is no liquidation. The protocol needs to use RUNE to repay enough TOR (full repayment) to help users get back the collateral. If the price of the collateral drops a lot, the user chooses not to repay (at the same time, this part of RUNE will not be recast, resulting in net destruction). In fact, the protocol does not want users to repay. If the price of the collateral rises and the price of RUNE falls, the user's repayment will cause inflation.

4. How to understand the deflation and inflation of RUNE as a medium of exchange

First, the total upper limit of all lending pools is determined by the RUNE Burnt in the gray part of the figure below multiplied by the Lending lever, and the 15mln RUNE Burnt is the result of the previous protocol burning non-upgraded BEP2/ERC20 RUNE. Therefore, it can be seen that the protocol currently has 15mln of room for inflation from the maximum supply of 500mln RUNE.

The above also introduces the role of RUNE in the entire borrowing process (you can review the above part about the mechanism). Opening a new loan will have a deflationary effect on RUNE assets, while closing a loan will have an inflationary effect on RUNE assets.

If the collateral increases when repaying, then when the RUNE price remains unchanged, more RUNE needs to be minted to redeem the required assets, which will lead to inflation; if the RUNE price increases, then it is ideal not to mint so many RUNE, and if the RUNE price falls, inflation will be more serious. If the collateral falls when repaying, and the RUNE price remains unchanged, users may choose not to repay (no minting will occur).

If the value of RUNE relative to BTC remains constant between when a loan is opened and closed, then there is no net inflationary effect on RUNE (the amount destroyed is the same as the amount minted minted minus exchange fees). However, if the value of the collateral asset relative to RUNE increases between when a loan is opened and closed, then there is net inflation on the RUNE supply.

To address inflation, lending controls are in place - there is also a circuit breaker design if minting causes total supply to exceed 5 million RUNE. In this case, the reserve will step in to redeem loans (not further minting), the entire lending system will be stopped and retired, but other aspects of THORChain will continue to operate normally.

If calculated based on the parameters in the figure, the total amount of all debt warehouses currently added up is only 4.95mln RUNE. That is, all debt warehouses can accept collateral equivalent to 4.95mln RUNE.

Source： GrassRoots Crypto

The RUNE Burnt of the entire Reserve is the buffer of all debt positions and the last resort for inflation. The total amount of RUNE Burnt* Lending lever in Reserve (currently) will be allocated according to the depth of each debt pool. The deeper the depth, the more Reserve buffer will be allocated. For example, the depth of BTC Lending pool is twice the depth of ETH Lending pool, then the value of Rune Burnt*Lending lever*depth coefficient in Reserve is the maximum collateral limit that can be taken in this lending pool. Therefore, when the price of RUNE rises, more collateral can be taken in this pool. It can also be seen that the price of Lending lever and RUNE jointly determine the upper limit of collateral that the lending pool can accommodate.

The THORChain protocol and all RUNE holders are counterparties to every loan. The burning/minting mechanism of RUNE means that RUNE condenses/dilutes (among all RUNE holders) when debts are opened and closed. When the RUNE-collateral exchange rate falls, inflation occurs, and vice versa, deflation occurs.

5. Is the CDP protocol a good on-chain storage model?

For Lending launched by Thorchain, it is such a disguised way of absorbing deposits and using RUNE as an indispensable medium in the borrowing and repayment process, adding the scenarios of destruction and minting.

So does this deposit-taking model have any advantages? Let’s first look at the deposit-taking models of some other tracks.

CEX is the most obvious beneficiary of the deposit-taking model because, as the custodian, this part of the funds can generate more income in many cases (after the reserve is required to be disclosed, this part of the income is much less than before). How to protect the safety of users' custodial funds is also something that the regulatory framework needs to clarify. Regulators usually hope that exchanges will have full reserves.

The situation on-chain is completely different.

After DEX absorbs deposits, it needs to give LP very high incentives. Therefore, the purpose of absorbing deposits is to deepen liquidity. It cannot directly use the "deposits" provided by LP to generate profits, but instead forms a liquidity moat through huge reserves.

Pure Lending is similar to Aave or compound, and requires paying interest costs for attracting deposits. The entire model is no different from traditional lending. For example, it requires active management of loan positions and has repayment time limits.

In comparison, the CDP model is a healthier model for attracting deposits. Due to the high volatility of collateral assets, most of the over-collateralized CDPs in the market are users who over-collateralize certain assets to obtain certain stablecoins/other assets. In this process, the CDP protocol actually obtains more "deposits". And there is no need to pay interest on these deposits.

Thorchain also belongs to this CDP model, so where is the collateral custodial? In fact, the collateral is exchanged for RUNE through the liquidity pool. Therefore, no one "stores" the collateral. As long as the THORChain pool is healthy and operating normally, any collateral deposited will be exchanged for RUNE, and then arbitrageurs rebalance the pool as usual. Here, the collateral can be seen as deposited in Thorchain's RUNE to other currency pairs. Precisely because collateral such as BTC enters the circulation market instead of being held in custody in the protocol, although the generated debt is 100% collateralized, the difference between the collateral value and the debt is determined by the value of RUNE, which casts a shadow similar to Terra LUNA over the entire mechanism.

Capital Sink may be one of the goals that Thorchain lending wants to achieve. It uses users' collateral assets to deposit into the asset liquidity in the swap pool. As long as users do not close their loans and the price of RUNE does not fall sharply, the protocol retains the assets, RUNE generates deflation, and forms a good positive cycle. Of course, the opposite will produce a negative spiral.

6. Risks

Collateral such as BTC enters the circulation market instead of being held in the protocol. Therefore, although the generated debt is 100% collateralized, the difference between the collateral value and the debt is determined by the value of RUNE, which casts a shadow similar to Terra LUNA over the entire mechanism. Since the RUNE burned when opening a loan and the RUNE minted when closing a loan are not necessarily completely equal, deflation and inflation will occur. It can also be understood that when the price of RUNE rises during repayment, deflation will occur, and vice versa. If the price of RUNE falls below the price of the lending lever when the position is opened, the circuit breaker will be triggered. During the entire lending process, the price of RUNE plays a decisive role in deflation and inflation. When the price of RUNE goes down, a large number of users choose to close their loans, and the risk of inflation is still very high. However, the protocol has strict risk control and risk isolation measures, so the overall risk is relatively small, and there will be no systemic risk similar to Terra LUNA. Even if a negative spiral occurs, it will not affect other functions of Thorchain.

Lending lever, CR and whether to open different collateral debt positions have become the three pillars of Thorchain lending risk control.

In addition, Thorchain has a history of theft, its code is highly complex, and Thorchain Lending may also have vulnerabilities that need to be suspended or fixed.

2. Conclusion

The launch of the Thorchain Lending product generates network linkage benefits, additional trading volume, and higher pool capital efficiency, driving the system to generate real returns, increasing the total amount of Total bonded, allowing Thorchain to gain potential upside by reducing the total amount in circulation (when the RUNE-collateral exchange rate rises).

Capital sink (absorbing deposits may be a goal that Thorchain lending wants to achieve) uses the user's collateral assets to deposit into the asset liquidity in the swap pool. As long as the user does not close the loan and the price of RUNE does not fall sharply, the protocol retains the assets and RUNE produces deflation, a good positive cycle can be formed.

But in fact, it is entirely possible that the reverse market trend will lead to inflation and a negative spiral. In order to control risks, the use of Thorchain lending is limited and the capacity is small. Overall, deflation and inflation will not have a fundamental impact on the price of RUNE at the current cap volume (up to 5 million RUNE).

In addition, Thorchain is not very capital efficient for users, with a CR between 200%-500% and may eventually float between 300%-400%. It is not the best product from the perspective of leverage alone. And although there is no borrowing fee, the multiple internal transaction fees are not user-friendly.

The evaluation of only one product, lending, cannot represent the development of the entire Thorchain DeFi product matrix. There will be a series of analyses on other Thorchain products in the future.

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