The Outlook for DeFi Lending Following the Stress Tests of 2022
Protocols that withstood this year’s credit crunch have the potential to emerge as critical infrastructure as the industry recovers.
The digital asset market has been shaken to its core by a series of institutional failures that culminated with the collapse of crypto exchange FTX, referred to by many as the industry’s “Lehman Brothers moment”. Amid ongoing fears of contagion risks, the debates on how it happened, how it was allowed to happen, and the countless ripple effects will no doubt persist for many years to come.
Lessons about this year’s disasters abound, but although the ashes are still smoldering, there are already positive signs for the industry’s future. An entire generation of crypto products and protocols will be defined by their ability to survive this year’s stress tests and re-emerge with product-market fit.
Protocols that withstood the tests of 2022 have the potential to re-emerge as critical pieces of market infrastructure and lead a more compliant industry into the next bull market. We believe Clearpool is one such example.
Since inception, and throughout the carnage of 2022, lenders in Clearpool’s Permissionless Pool protocol have not suffered any losses to date. Clearpool’s mechanics have worked as intended, despite systemic risk spreading through the market.
In this article, we outline how the protocol operated through 2022 and managed to absorb the shocks of contagion in a robust way, and how it is positioned as a market leader for the future growth in uncollateralized digital asset lending.
Clearpool Mechanics
Clearpool is a decentralized marketplace, built on smart contracts, that matches institutional borrowers with a decentralized network of lenders. Institutions which have been KYC’d and whitelisted each control their own borrower pools — a smart contract running on Ethereum or Polygon. Lending is permissionless (open to all) and lenders (also known as liquidity providers, or “LPs’’) are free to select which of the borrower pools they want to fund.
As LPs fund a pool, the borrower is able to draw down on the supplied liquidity at any time. As they do so, the utilization rate — the percentage of the pool’s liquidity that the borrower is utilizing — increases and subsequently determines the pool’s interest rate.
The image above shows the interest rate curve, which is integral to each borrower pool. The lowest rate on this curve is found at 85%, thus incentivizing borrowers to optimize utilization in this area. The remaining ~15% of liquidity is left available in the pool for LP withdrawals.
Click here to learn more about Clearpool’s innovative interest rate mechanism.
Importantly, this unique mechanism ensures that LPs are not locked into a term loan, so they can effectively withdraw funds whenever they wish if there is sufficient pool liquidity. However, during periods of market volatility and risk aversion, when many LPs withdraw liquidity at the same time, the mechanism can force a pool into high-utilization and higher interest rates.
This dynamic provides those LPs remaining in the pool with higher yields, compensating them for the increase in liquidity risk. High-utilization, however, can also draw new liquidity to the pool from less risk-averse lenders looking to farm the higher yield. In the absence of new liquidity entering the pool, the borrower is incentivized to repay liquidity to the pool in order to optimize utilization and interest rate levels.
How Clearpool Worked-As-Intended
In the days following the FTX bankruptcy, many of the borrowers on Clearpool decided to repay in full — allowing all LPs in their pool to fully withdraw funds. The protocol’s unique design facilitated the safe unwinding of some $150 million of risk. Let’s take a closer look at how this played out.
When Coindesk first broke news of Alameda’s fragile balance sheet which was overexposed to illiquid assets like FTT, the total liquidity provided (TLP) to all borrower pools on Clearpool was $153.4 million.
The events that unfolded following the article’s publication created one of the most volatile periods in crypto markets history. Globally, market participants rushed to withdraw liquidity from digital asset exchanges, protocols and platforms, creating a self-fulfilling run on liquidity across these market venues.
Withdrawals from the borrower pools on Clearpool began to occur between the 6th and 9th of November, when Binance CEO Changpeng Zhao announced the company would be selling its FTT holdings, then considered acquiring FTX before ultimately pulling out of that deal.
Although Clearpool’s TLP at this point had dropped about a third to approximately $100 million, all borrower pools on the protocol were still in the active state. The protocol’s mechanism continued to work as intended, with borrowers maintaining optimal utilization, albeit at more regular repayment intervals to service the growing LP demand for withdrawals.
A few days later, however, as news emerged that FTX had now filed for Chapter 11 Bankruptcy, market sentiment grew more negative, rumors of contagion effects began to swirl, and the race for liquidity intensified. On Clearpool, LPs continued to manage their risk by withdrawing liquidity.
Now according to the protocol’s design, when LPs withdraw the maximum amount of liquidity from a borrower pool, utilization spikes to 99%. At this point, the protocol allows for a 120-hour (5 day) grace period within which the borrower must return utilization below 95% in order to avoid default.
Rather than continuing the process of repaying liquidity to their pools at increasingly frequent intervals to service withdrawals, borrowers become more incentivized to fully repay the pool.
Following the announcement of FTX’s bankruptcy, on average, it took just 2.9 days for the above borrowers to fully repay their pools on Clearpool. This is in contrast to other uncollateralized lending protocols, where fixed loans originated before FTX’s failure were, and in some cases still are, yet to mature. This exposes lenders locked in those pools to growing risk and uncertainty, without compensating them with higher interest rates in the meantime.
The end result for Clearpool and its users is that there is very little risk remaining on the protocol — a testament to the protocol’s strengthening of risk management capabilities within decentralized finance.
All other borrowers and lenders are now in a position to monitor the market and decide when to become active again.
The above tweet captures the contrast between the Clearpool mechanism and that of other uncollateralized lending protocols. You can find the Twitter Thread here.
Less than three weeks after this tweet, Orthogonal Trading, a digital asset hedge fund, defaulted on $36 million of term loans it had taken out on another uncollateralized lending platform, leaving that platform’s LPs suffering major losses.
Looking Ahead
Clearpool launched in March 2022, in the midst of a crypto bear market and just before a historic chain of events that ultimately resulted in the fastest credit collapse in the industry’s history. Clearpool’s mechanism worked as intended through the collapse of Terra’s UST stablecoin, the hedge fund Three Arrows Capital, and centralized lenders Celsius and Voyager, as well as during the $160 million hack on Wintermute, one of the protocol’s largest borrowers.
Following each of these events, Clearpool’s total liquidity hit new highs, as DeFi lenders increasingly valued greater access to, and control of, their funds when lending on Clearpool as compared to other uncollateralized lending protocols. As the dust settles following the latest bout of volatility, liquidity volume on Clearpool is expected to return and grow significantly as lenders and borrowers in the market become active once again with increased awareness and appreciation for risk management.
Crypto’s historic credit crunch has also created opportunities for Clearpool to build a number of new products planned for launch in 2023. In June of this year, Clearpool launched its first permissioned pool with Jane Street, a large Wall Street trading firm. Permissioned pools have both KYCd borrowers and lenders to cater for the growing demand from traditional financial institutions looking to access DeFi markets.
Clearpool has built and will launch a more sophisticated product solution for permissioned pools early in the new year, with a number of high-profile institutions as users.
Other products are in the pipeline as well. Term pools and diversified pools are on the way, as well as a secondary market where the LP tokens that lenders receive when they participate in these products can be traded, providing an additional venue for liquidity.
TL;DR
Clearpool is a free market, built on smart contracts and driven by the forces of supply and demand. This model, which eliminates the possibility of centralized intervention, has performed in a superior way to centralized lending platforms and other less innovative DeFi protocols, many of which suffered immensely during the heightened market volatility of 2022 from defaults, losses and all-out failures.
Within days of the FTX bankruptcy, one of the most extreme events to happen in the history of digital assets, the Clearpool Permissionless Pool protocol facilitated the safe unwinding of over $150 million of risk, without any losses. This happened autonomously, through the behavior of the protocol’s participants, incentivized only by its hard-coded mechanisms.
Despite a tumultuous period for the wider digital asset industry, the demand for uncollateralized loans will only continue to grow. Clearpool, with its proven and stress-tested protocol, and with new innovative product additions planned for 2023, will emerge from the current bear market as critical infrastructure and a clear leader in this space.
