A Deep Dive Into Interest Protocol
A new money market protocol improves lending and borrowing efficiency by issuing their native stablecoin
Interest Protocol (IP) is the latest DeFi protocol developed by GFX Labs. They are the creators of other products in web3 such as Etherlands or Poppie Card. IP is a multi-asset money market in the Ethereum blockchain with its own stablecoin, USDi. Our readers would be right to start to think of similarities with MakerDAO and DAI.
The protocol has been live since mid June, allowing to open collateralized debt positions (vaults) against WBTC, ETH and UNI tokens. The process involves depositing these assets and obtaining USDi in return. This effectively allows borrowers to gain leverage over the assets that are deposited.
This functionality covers the demand side, but what about the supply side? IP allows depositors to lend USDC and earn yield. The protocol offers a native 1:1 swap of USDC and USDi. A diagram of the interaction between the different entities and the protocol can be found below:
Currently IP has gained over $10M in TVL, and is looking to release soon their governance token known as IPT.
USDi, the stablecoin
USDi is overcollateralized by USDC and a basket of crypto assets formed by those that have been lent to open vaults. USDi is minted when an equivalent amount of USDC is deposited into the protocol (depositing USDC or by borrowing USDi). USDC is never lent out, only USDi. The stablecoin automatically pays interest to holders via rebasing, which is very gas efficient. This yield comes from the interest paid by borrowers. USDi is minted to generate loans, and burns it when loans are repaid.
The arbitraging mechanism that keeps USDi close to 1 involves buying USDi in an AMM pool (either Uniswap v2 or Curve) when it’s trading above $1 and exchanging it for $1 of USDC through the native swap mechanism of protocol. Then USDi trades below $1, it can be arbitraged likewise by depositing USDC in the protocol, borrowing USDi (mint) and selling USDi in the AMM pool.
The USDi peg has remained relatively stable after its launch, and right now has a market cap of $8.3M. Here can be seen its price according to their USDi-ETH pool in Uniswap:
Risk assessment
All protocols are susceptible to technical risks such as smart-contracts hacks. One could warn that IP is not a fork of any known protocol, so its code is not as battletested as others. Nevertheless, we found their Dedaub audit to be very complete, and so far IP haven not had any incident on the matter. Money market protocols are especially susceptible to economic risks. Different protocol parameters can make these protocols insolvent, and/or make their lenders unable to withdraw. IP approaches this with two concepts in mind: liquidity risks and credit risks.
Liquidity risk is defined by IP as the ability to meet redemption demand. This means the capability of lenders to recover their assets. This is mitigated by a reactive interest rate function that quickly incentivizes borrowers to repay USDi loans or deposit more USDC based on the lending and borrowing demand (USDi supply inflation and contraction). As well as an interest curve that is more generous than other protocols thanks to the over-collateralization of USDi: there is always a higher value of USDi circulating than the value of the USDC deposited. This facilitates higher utilization rates than other protocols:
The second risk is credit risk. It is defined as the risk of borrowers defaulting on their loans. This is usually caused because some positions become unprofitable to liquidate and the protocol accrues bad debt. In that case some of the lenders might be unable to withdraw their assets.
The problem is exacerbated if the protocol allows high leverage, which is the case for IP since the loan-to-value parameters of its vaults are high: ETH (LTV 85%), WBTC (LTV 80%), UNI (LTV 50%). This is slightly higher than most of the competition such as MakerDAO, Aave or Compound. Vaults that are opened with high LTV values are more likely to result in liquidations.
Usually lending/borrowing protocols liquidate either the full position or 50% of it. This is done in order to be safe in case of large market moves. IP implements partial liquidations. This allows the liquidation of the minimal amount of balance of a vault that is liquidatable. In this way a liquidatable vault is out of liquidation risk with a minimal loss of capital. Therefore partial liquidations are the perfect match to high LTV rates. The downside of that is that liquidations might take longer if the price of the collateral decreases fast, compared to the systems.
Protocol Insights
IP combines two power ideas: over-collateralization and fractional reserve, to provide a product that is presumably more capital efficient and safer than its competitors. This efficiency is possible thanks to issuing their own stablecoin. The issuing mechanism of this stablecoin when there is loan demand reminds us of how money is created by central banks. Speaking of central banks, stablecoins such as FRAX or DAI already employ similar techniques to the one the FED uses, called Open Market Operations. We can envision a future where IP takes a similar approach and tries to keep a suggestive target in their interest rates by inflating or deflating their stablecoin supply according to how its stablecoin is trading.
Leaving capital efficiency aside, categorizing IP as “safer” than similar protocols comes from their approach to liquidity risk. Liquidity in DeFi lending markets have been traditionally concentrated among several whales, which has caused liquidity crushes more than once. IP tries to mitigate that with a novel approach in which their stablecoin enables them to have a higher amount of debts than other protocols, considering the amount of USDC that is lent.
We can predict that the success of IP will depend on how well they balance both the supply and demand of its market. This is a symbiotic relationship in DeFi where those that seek to lend USDC in a safe and efficient way will have to be rewarded with a compelling rate of return. While those borrowing will be seeking to pay as little as possible for their leverage appetite.
We are very keen for DeFi to evolve towards new protocols that innovate in areas such as capital efficiency and security in ways such as the one envisioned by Interest Protocol . It might be earlier to evaluate if these will work as expected, but until then we will make sure to keep an eye on IP and how it performs over time.
This article is solely for informational purposes, not intended as financial or investment advice. Any opinions on this piece reflect solely those of the author and not the company’s.
