PSE Trading | Is the No-Liquidation Protocol a Ponzi scheme?

Difficulty:newbie

Tags: DeFi

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This article introduces no-liquidation protocols and explores whether they are a Ponzi scheme.

Author: PSE Trading Analyst @DanielFlower

Introduction

As blockchain has developed, the DeFi sector has matured, with lending being a core component. During bull markets, lending often serves as the engine that propels the market. Investors commonly collateralize BTC, borrow USDT, use it to buy more BTC, driving the market higher and generating additional returns. However, with the fading enthusiasm in the cryptocurrency market, a decline in BTC prices often leads to a cascade of liquidations, causing BTC prices to plummet. To achieve the goal of an “eternal bull market,” many “no liquidation” protocols have been introduced to the market. These protocols allow investors to enjoy additional returns without facing the risk of liquidation. This article will provide an overview of several common “no liquidation” protocols in the market. In conclusion, the so-called “no liquidation” essentially transfers the risk, and while investors profit, someone else bears the risk.

1. Differences in No Liquidation Protocols

1.1 “Liquidation” in Advance with Other Collateral Assets

Thorchain is a typical representative in this category. Thorchain is a cross-chain protocol that establishes various asset pools on different chains, such as BTC/RUNE (Rune being the platform’s native token). When users need to trade cross-chain assets, they exchange BTC on the Arb chain for Rune, then exchange Rune for ETH on the OP chain. During the lending process, BTC is exchanged for Rune, Rune is burned to generate Thor BTC (synthetic asset), Thor BTC is exchanged for Thor TOR (official stablecoin) through burning and minting Rune, and finally, Rune is exchanged for USDT. In this process, Rune will ultimately be deflationary because it is burned to generate USDT, and users need to pay swap fees to LP for each swap. Unlike traditional lending protocols, users “collateralize” USDT to borrow USDT, so there is no need to worry about the increase in BTC prices, leading to never experiencing liquidation, or one could say that the “liquidation” has been done in advance.

Figure 1 Thorchain Lending Process

If the protocol has no “liquidation” and no interest, borrowers can potentially never repay the loan. However, an extreme situation arises during a bull market when borrowers may want to repay the loan to retrieve more profit from the rising BTC prices. The process is as follows: USDT is exchanged for Rune, Rune is burned to mint Thor TOR, Thor TOR is exchanged for Thor BTC, which is then burned to generate Rune. Finally, Rune is swapped back to BTC and returned to the borrower. In this process, Rune becomes a significant variable as it is minted to reclaim the collateralized BTC. If too many borrowers repay, an “unlimited” supply of Rune could be minted, ultimately leading to a collapse.

Figure 2 Thorchain Repayment Process

Therefore, Thorchain sets a maximum minting quantity, i.e., the debt ceiling, currently set at 500 million. The native Rune supply is 485 million, allowing for the minting of up to 15 million Rune. Thorchain establishes a lending level value that, when multiplied, equals the quantity of Rune that can be burned. Based on the current price of Rune, the USDT value that can be borrowed is determined.

Figure 3 Total Supply of Rune

Additionally, the price relationship between Rune and BTC is crucial for the success of the protocol. The following two charts illustrate that when both BTC and Rune prices rise by 20%, users repaying will mint an additional 301 Rune compared to the Rune burned during borrowing. However, when the price of Rune rises by 30%, no additional Rune will be minted during repayment, and the protocol remains in a state of deflation. Conversely, if the price of BTC rises significantly more than the price of Rune, the protocol will mint more Rune, leading to a mechanism collapse. When the minting quantity is approaching the upper limit, the protocol will increase the collateral ratio to a maximum of 500%, forcing users to borrow less USDT. Assuming the upper limit of 500 million Rune is reached, the protocol will halt all lending and repayment activities until the BTC price falls, and no more Rune needs to be minted.

Figure 4 Impact of Rune Price Changes on the Protocol

Figure 5 Impact of Rune Price Changes on the Protocol

It is evident that the protocol benefits when it constantly borrows, leading to deflation of Rune. However, it cannot withstand large-scale repayments, resulting in Rune inflation. Therefore, Thorchain’s model is inherently limited in scale, facing a fate similar to the tragedy of Luna 2.0 if aiming for significant growth. Furthermore, due to the control of loan quantity through collateral ratio, the platform’s CR ranges from 200% to 500%, much higher than traditional lending platforms like AAVE with ratios of 120-150%. This low capital utilization is also unfavorable for meeting the borrowing demands of mature markets.

1.2 Shifting Liquidation Risk to Lenders

Cruise.Fi is a collateral lending platform using stETH as collateral. By outsourcing the liquidation risk to other lenders, theoretically preventing liquidation as long as users continue to step in, both borrowing users and those taking over positions benefit. For borrowing users, the risk of liquidation is reduced, providing more room to withstand market fluctuations. For users taking over positions, additional earnings are achievable, including basic lending returns plus extra ETH rewards.

Borrowing Process:

After users collateralize stETH, USDx is generated. Users can convert USDx to USDC through the Curve pool. The interest generated by stETH is ultimately given to the lender. Two methods are employed to maintain the price of USDx:

1.When the USDx price is high, a portion of stETH earnings is given to the borrower to subsidize their high borrowing costs.

1. When the USDx price is low, a portion of stETH is converted into borrowing costs, subsidizing the lender.

Figure 6 USDx Price Curve

So, how does the project avoid liquidation? Let’s assume the collateralized ETH is $1,500, and the liquidation price is $1,000. When liquidation occurs, the platform first locks the collateral (stETH) and then gives the stETH staking rewards to the borrower. By using stETH staking rewards, a portion of the original position is retained. Positions exceeding the stETH reward portion are suspended. However, the drawback is that when the ETH collateralization rate increases, it affects stETH earnings, reducing the size of the retained position.

Regarding the positions originally slated for liquidation, the platform generates Price Recovery Tokens (PRT). When ETH returns above the liquidation line, lenders can exchange this portion of PRT at a 1:1 ratio for ETH. This adds an additional layer of excess returns in ETH compared to traditional lending platforms, which solely provide interest returns. Of course, if lenders do not believe ETH will rise above $1,000, they can sell PRT on the secondary market. As the project is still in the early stages, many data points and secondary market aspects are not yet refined. The author also makes a bold prediction that if lenders sell PRT on the secondary market, borrowers can “buy back” their positions at lower prices (compared to replenishing) and still receive future excess ETH returns.

Figure 7 Process of Redeeming ETH

However, the project also has a downside. It can only thrive in a bull market (even if a major correction occurs, there will be “believers” in ETH providing liquidity). If a bear market arrives, and market sentiment plunges to freezing point, liquidity will dry up, posing a significant threat to the platform. Moreover, there may not be many users willing to be lenders on the platform because the protocol inherently shifts all risks onto lenders.

1.3 Interest Covering Borrowing Rates

The wave of interest rate hikes by the Federal Reserve has also led to a wave of “no liquidation” Real World Asset (RWA) protocols. The most noteworthy and largest-scale one is the T Protocol, with STBT being a tokenized representation of US Treasury bonds issued by the MatrixDock institution, pegged 1:1 to US Treasury yields. TBT is the T Protocol’s version of STBT, distributed using a rebase mechanism that delivers US Treasury bond yields to platform users. Users only need to deposit USDC to mint TBT and enjoy the benefits of US Treasury bond yields.

Figure 8 Internal Process of T Protocol

The main highlight is that the interest charged by the platform is always less than the US Treasury bond yield. Assuming a US Treasury bond yield of 5%, the platform charges an interest rate of approximately 4.5%, which is then distributed to the lender. 0.5% of this amount is retained as a fee. This allows MatrixDock to collateralize US Treasury bond-wrapped tokens for interest-free borrowing. However, how does the platform address the issue of no liquidation? Essentially, the platform employs the logic of collateralizing USD to borrow USD, independent of the influence of assets like BTC. Currently, the Loan-to-Value ratio (LTV) is 100%. When MatrixDock collateralizes one million US dollars in US Treasury bonds, it can borrow one million US dollars in stablecoins. When a user wishes to retrieve their stablecoins, MatrixDock will liquidate its owned US Treasury bonds, paying the user an equivalent amount. Larger users may need to wait for three business days to complete the transaction.

However, there are potential risks. Once MatrixDock receives the loan, if it engages in high-risk investments or other activities, users face the risk of being unable to redeem their US Treasury bonds. Trust relies entirely on the platform and the US Treasury institution, creating regulatory blind spots and opacity. Therefore, the T Protocol’s process of seeking collaboration with other US Treasury institutions is exceptionally slow, and there are limitations to its growth. Additionally, with future loose monetary policies, US Treasury bond yields are likely to decline. When interest income decreases, users may find it unnecessary to deposit funds in the platform and may turn to other lending platforms.

1. Conclusion & Reflection

The author believes that most “no liquidation” protocols so far are “pseudo no liquidation.” In essence, they shift the risk from borrowers to other entities, such as Thorchain shifting the risk to the protocol itself and Rune token holders, Cruise.Fi shifting the risk to lenders, and T Protocol shifting the risk to opaque regulation. It is evident that these protocols share a pain point: it is challenging to achieve economies of scale because lending itself is inherently unfair to one party. The short-term “high” returns generated by this unfairness are difficult to sustain and are perceived as unstable by users. Ultimately, users are likely to use traditional lending platforms like AAVE, embracing fairness alongside the risk of liquidation. The essence of liquidation is that the assets do not cover the debt, and as long as there is volatility, there will be times when assets do not cover debt. In the world, there is no such thing as a risk-free investment. As long as there is volatility, there will be moments when assets do not cover debt. Traditional finance has not “designed” a perfect risk-free investment from its inception to the present day. The high volatility in the cryptocurrency world makes it even less likely. “No liquidation” protocols may reappear in the public eye in a relatively “stable” manner, but someone will ultimately bear the painful cost.

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