By delving into Thorchain’s new lending module launched on August 22nd, we discovered the shadow of Terra LUNA. The similarity between LUNA and Thorchain lies mainly in the fact that the collateral deposited by users is converted into RUNE. In reality, the inflation and deflation of RUNE are determined by the fluctuation of the RUNE-collateral exchange rate. Just like how LUNA absorbs the volatility of UST, RUNE absorbs the volatility of the RUNE-collateral exchange rate through inflation and deflation. However, there are differences in their manifestations (RUNE participating in lending, being destroyed and minted when opening and closing loans, while LUNA participates in stablecoin anchoring, being destroyed and minted by arbitrageurs when UST becomes unanchored) and the underlying risk volume (LUNA has unlimited minting, while RUNE has inflation and deflation limits and only 50% of the collateral for synthetic assets is RUNE). Moreover, the lending protocol 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’s lending include no interest, no liquidation risk, and no time limit (during the initial period, the minimum loan term is 30 days). For users, it essentially means being short USD and long BTC/ETH as collateral assets; for the protocol, it essentially means being short BTC/ETH and long USD. The debt is denominated in TOR (Thorchain’s USD equivalent), so users are similar to purchasing BTC OTM calls during the gold standard period, and the protocol/RUNE holders are 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 be converted into RUNE, then destroyed, and finally minted into the assets required for the RUNE exchange. In this process, the difference between the value of the collateral and the debt, excluding fees, corresponds to the net destruction value of RUNE.
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If the collateral rises at the time of repayment, and assuming the RUNE price remains unchanged, more RUNE needs to be minted to exchange for the required assets, which will lead to inflation. If the price of RUNE rises, it is ideal to mint less RUNE. If the price of RUNE falls, inflation will be more severe. If the collateral falls at the time of repayment and the RUNE price remains unchanged, users may choose not to repay (no minting occurs).
If the value of $RUNE remains unchanged relative to $BTC when opening and closing a loan, then $RUNE will not have a net inflationary effect (the amount destroyed is the same as the amount minted, minus the exchange fees). However, if the value of the collateral relative to RUNE increases between the opening and closing of the loan, then there will be a net inflation of $RUNE supply.
To address the inflation issue, lending control measures have been put in place. If minting causes the total supply to exceed 5 million RUNE, there is a circuit breaker design. In this case, reserves will intervene in loan redemption (instead of further minting), the entire lending design will be stopped and discontinued, but other aspects of THORChain will continue to operate normally.
Therefore, the entire lending process has a significant impact on the inflation and deflation of RUNE. However, inflation and deflation both have upper limits when the overall lending cap is low. When the RUNE-collateral ratio rises infinitely, the maximum deflation is the maximum opening amount, currently 15 million * 0.33 (0.33 is the lending lever, might change), which is 4.95 million (may increase in the future). In the case of the RUNE-collateral ratio falling infinitely, inflation is also controlled within 5 million by a circuit breaker.
Specifically, if a user overcollateralizes by 200% and borrows 50% of the required assets, the other 50% is minted based on the RUNE-collateral ratio when redeemed. This step is essentially similar to LUNA, but under the mechanism of Thorchain Lending, where the Rune back only accounts for 50% and the product capacity is relatively small, overall risk is relatively low and will not generate systemic risk like Terra LUNA. This risk is isolated and even in the event of a negative spiral, it will not affect other functions of Thorchain.
1. How to understand that the design of lending is similar to a deep out-of-the-money, resettable strike price call option for users
When Alice provides 1 BTC, she also receives 50% cash (with a CR of 200%) and the opportunity to purchase 1 BTC with this cash.
If, at the time of repayment (assuming one month later), BTC rises, Alice repays the debt (i.e., the value of 50% of BTC from one month ago) and purchases this BTC at the price from one month ago. If it drops significantly, exceeding 50%, Alice chooses not to repay, and the protocol will not generate inflation caused by minting RUNE (for Alice, her long position fails).
2. How to understand the absence of borrowing interest
It can be seen as users paying multiple swap fees instead of an interest rate, and it is essentially a CDP product. If borrowing interest is also charged, the attractiveness of this product to users will be even smaller.
The entire process of lending is as follows:
Users deposit collateral in native assets (BTC, ETH, BNB, ATOM, AVAX, LTC, BCH, DOGE). In the initial stage, the collateral is limited to BTC and ETH. The maximum amount of collateral that each vault can accept (vault cap) is determined by the hard cap (15 million), lending lever, and pool depth coefficient. Overcollateralization generates debt, and the proportion of debt that can be obtained is determined by the CR.
Borrowing: Alice deposits 1 BTC, which is first swapped for RUNE in the BTC-RUNE swap pool. These RUNE enters a V BTC pool and is destroyed while being converted into a synthetic asset, Thor.BTC. The collateral for the synthetic asset is constant product liquidity, always 50% of the asset is collateralized, and the remaining 50% is RUNE. Then, the synthetic asset Thor.BTC is sent to an internal module, where a dynamic CR (collateral ratio) determines how much loan can be obtained, and Thor.Tor (similar to USD) tokens are generated as the accounting means for the loan. The next step is the generation of USDT loans, which are given to Alice for her use.
Repaying loans: When Alice repays the loan, she sends all USDT or other Thorchain-supported assets to the protocol and converts them into RUNE. RUNE will be minted into Tor. The protocol checks whether the user has repaid all loans priced in Tor. If all loans are repaid, the collateral will be released and converted into derived collateral (Thor.BTC). Then, this derived asset will be reminted into RUNE and swapped back to L1 BTC. RUNE is minted during this process.
It should be noted that these swap and convert processes will incur fees (at least 4 swap fees per loan), so the total amount of repayment needs to be slightly higher than the actual amount to cover these swap fees. Although there is no interest, these multiple fees can be considered as a substitute for interest. Although there is significant wear and tear, the RUNE form of fees generated during this process is burned, which is a real deflation.
3. How to understand no liquidation and no repayment time limit
Since the debt priced in TOR stablecoin is fixed, although borrowers can choose any asset for repayment, they will actually be converted into RUNE through the market. Liquidity providers and depositors do not directly lend their assets to borrowers. The pool is only a medium for exchange between collateral and debt, and the entire process is a gambling behavior, which is why there is no liquidation. The protocol requires the user to repay enough TOR (complete repayment) with RUNE in order to help the user retrieve the collateral. If the price of the collateral drops significantly, the user may choose not to repay (and this part of the RUNE will not be reminted, resulting in net burning). In fact, the protocol does not want users to repay. If the price of the collateral rises and the price of RUNE drops, repayment by users will result in inflation.
4. How to understand the deflation and inflation of RUNE as a medium of exchange
First of all, the total upper limit of all lending pools is determined by multiplying the RUNE Burnt part in the gray area of the following figure by the Lending lever. The 15 million RUNE Burnt is the result of the protocol burning non-upgraded BEP2/ERC20 RUNE. Therefore, it can be seen that the protocol still has a space of 15 million before reaching the maximum supply of 500 million RUNE, which can cause inflation.
The above text also introduces the role of RUNE in the entire lending process (you can review the mechanism part in the previous text). 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 rises during repayment and the price of RUNE remains the same, more RUNE needs to be minted to exchange for the required assets, which will cause inflation. If the price of RUNE rises, it is ideal to mint less RUNE. If the price of RUNE drops, inflation will be more severe. If the collateral falls during repayment and the price of RUNE remains the same, the user may choose not to repay (no minting is generated).
If the value of RUNE relative to BTC remains the same when the loan is opened and closed, RUNE will not have a net inflationary effect (the amount burned is equal to the amount minted minus the exchange fees). However, if the value of the collateral relative to RUNE increases between loan opening and closing, there will be a net inflation of RUNE supply.
In order to solve the inflation problem, loan control measures have been put in place – if minting causes the total supply to exceed 5 million RUNE, there is a circuit breaker design. In this case, the reserves will intervene to redeem the loans (instead of further minting), the entire lending design will stop and be discontinued, but other aspects of THORChain will continue to operate normally.
If calculated with the parameters in the graph, currently all debt pool vaults only amount to a total of 4.95 million RUNE. That is, all debt pools can accept collateral equivalent to 4.95 million RUNE.
The entire RUNE Burnt in the Reserve is the buffer for all debt pool vaults and the last resort for inflation. The total amount (currently) of RUNE Burnt in the Reserve * Lending lever will be distributed according to the depth of each debt pool vault. The deeper the depth, the more Reserve buffer will be allocated. For example, if the depth of the BTC lending pool is twice that of the ETH lending pool, the value of Rune Burnt * Lending lever * depth coefficient in the Reserve represents the maximum collateral limit that can be accommodated in this lending pool. Therefore, as the price of RUNE rises, more collateral can be accepted in this pool. It can also be seen that the lending lever and the price of RUNE jointly determine the maximum collateral limit that the lending pool can accommodate.
The THORChain protocol and all RUNE holders are counterparties to each loan. The burning/minting mechanism of RUNE means that RUNE is condensed/diluted (among all RUNE holders) when a debt is opened or closed. When the RUNE-collateral ratio decreases, inflation occurs, and vice versa for deflation.
5. Is the CDP protocol a good on-chain capital absorption model?
For the Lending introduced by Thorchain, it is a disguised capital absorption model in which RUNE is an essential medium in the borrowing and repayment process, increasing the scenarios for burning and minting.
So, is this capital absorption model advantageous? Let’s first look at some other capital absorption models in different fields.
CEX is the most obvious beneficiary of the capital absorption model because it acts as a custodian and can generate more profits with these funds in many cases (after the reserve is disclosed, this part of the profit is reduced compared to before). How to protect the security of user custodial funds is something that regulatory frameworks need to clarify, and regulators usually expect exchanges to have full reserves.
The situation on-chain is completely different.
DEX needs to provide high incentives to LP after capital absorption, so the purpose of capital absorption is to deepen liquidity, and it cannot directly generate profits using the “deposits” provided by LPs. Instead, it forms a liquidity moat through a large reserve.
Pure Lending, similar to Aave or Compound, requires paying interest costs for capital absorption. The entire model is no different from traditional lending, such as the need to actively manage loan positions and have repayment deadlines, etc.
Compared with the CDP model, the absorption model is a healthier model. Due to the volatility of the collateral assets, most of the over-collateralized CDPs in the market are users over-collateralizing certain assets to obtain a certain stablecoin/other assets. In this process, the CDP protocol actually obtains more “deposits”. And there is no need to pay interest on this part of the deposits.
Thorchain also belongs to this CDP model. Where is the collateral held? In fact, the collateral is exchanged for RUNE through the liquidity pool. Therefore, no one is “storing” the collateral. As long as the THORChain pool is healthy and operating normally, any collateral deposited will be exchanged for RUNE, and then arbitrageurs will rebalance the pool as usual. This can be seen as the collateral being deposited into Thorchain’s RUNE against other currency pairs. Because BTC and other collateral enter the circulation market rather than being held in the protocol, although the generated debt is 100% collateralized, the difference between the value of the collateral and the debt is determined by the value of RUNE, thus casting a shadow over the entire mechanism similar to Terra LUNA.
Capital Sink may be one of the goals that Thorchain lending wants to achieve, using users’ collateral assets to settle as liquidity in the swap pool. As long as users do not close their loans and the price of RUNE does not fall significantly, the protocol retains assets, RUNE generates deflation, and forms a good positive cycle. Of course, the opposite will create a negative spiral.
Because BTC and other collateral enter the circulation market rather than being held in the protocol, although the generated debt is 100% collateralized, the difference between the value of the collateral and the debt is determined by the value of RUNE, thus casting a shadow over the entire mechanism similar to Terra LUNA. Since the amount of RUNE burned when opening a loan and the amount of RUNE minted when closing a loan may not be exactly equal, both deflation and inflation can occur. It can also be understood that if the price of RUNE rises during repayment, deflation occurs, and vice versa, inflation occurs. If the price of RUNE falls below the lending leverage multiplied by the opening price, the circuit breaker will be triggered. Throughout the lending process, the price of RUNE plays a decisive role in deflation and inflation. When the price of RUNE goes down, there is still a high risk of a large number of users choosing to close their loans and causing inflation. However, the protocol 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.
Lending leverage, CR, and the choice of opening different collateral debt warehouses have become the three main pillars of Thorchain lending risk control.
In addition, Thorchain has a history of being stolen, and its code is relatively complex. Thorchain Lending may also have vulnerabilities that need to be suspended or fixed.
The launch of Thorchain Lending products generates network synergies, additional trading volume, and higher pool capital efficiency to drive real returns for the system, increase the total bonded amount, and allow Thorchain to potentially gain upward momentum by reducing circulation (when the RUNE collateral rate rises).
Capital sink (which may be one of the goals of Thorchain Lending) uses users’ collateral assets to deposit liquidity into the swap pool. As long as users do not close their loans and the price of RUNE does not experience a significant decline, the protocol retains assets and RUNE experiences deflation, creating a positive feedback loop.
However, in reality, reverse market trends can lead to inflation and negative spirals. To control risks, the use of Thorchain Lending is limited and has a small capacity. In terms of overall deflation and inflation, considering the current capped volume, it will not fundamentally impact the price of RUNE (at most, an impact of 5 million RUNE).
Furthermore, for users, the capital efficiency of Thorchain is not high, with a collateral ratio ranging from 200% to 500%, and ultimately floating between 300% and 400%. From a leverage perspective alone, it is not the best product. Although there are no borrowing costs, the multiple internal transaction fees can be burdensome for users.
Only evaluating the lending product does not represent the development of the entire Thorchain defi product matrix. There will be a series of analyses on other Thorchain products in the future.