All About Yield — Exploring Option Selling and Payoffs in MYSO v2
A look at how MYSO v2 implements optionality and how various market scenarios impact yield capture for lenders
The MYSO v2 testnet is currently live here: https://testnet.myso.finance/
MYSO v2 represents a mass overhaul of Zero-Liquidation Loans in terms of capital efficiency, scalability, ease-of-use, and flexibility. We’ve made numerous upgrades on both borrowing and lending, enhancing accessibility for DeFi users of all experience levels.
We’ve explored some of the underlying architecture and value-adds of the upcoming v2 in previous Medium pieces— with that being said, we’d like to revisit a key mechanism that’s been at work in Zero-Liquidation Loans (ZLLs) since the v1 which represents how yield is generated and the associated payoffs for lenders in any kind of market scenario.
As you may know, each interaction on a peer-to-peer MYSO market represents a matched borrower and lender — one who provides collateral to take out a ZLL, and one who loans out some borrow currency.
Intuitively, borrowers are thus given the right, but not the obligation, to repay the loan and reclaim their pledged collateral. Since the lender is implicitly selling a simple option, borrowers do not have to deal with the complexities of option knock-out levels (liquidation thresholds) found on conventional lending protocols. However, there now exists a risk that the value of the pledged collateral becomes less than that of the loaned amount and borrowers might choose to then not repay the loan prior to expiry. If this situation occurs, the lender bears the downside risk and ends up retaining the borrower’s pledged collateral. To make things fair for both sides, the lender should be compensated for this in the form of an adequate, risk-adjusted yield.
The above is the simplified structure for a Zero-Liquidation Loan — but how would this look in practice, and what would a lender’s yield look like in different market scenarios?
Lender Payoffs in a Zero-Liquidation Loan
First, let’s describe a theoretical loan:
- Assume 1 ETH = $2000 USDC
- Lender sends out a loan offer where they agree to lend out USDC against wETH collateral at 80% LTV with a 1 year tenor
- Lender sets a 12.50% interest rate on this loan
Let’s say a borrower arrives and finds these terms attractive — they agree and pledge 1 wETH and borrow $1600 worth of USDC — now what?
The borrower has entered a Zero-Liquidation Loan and they have the right (*but not the obligation*) to reclaim their 1 wETH collateral if they repay ~$1800 USDC. In this case, a rational borrower would repay if the price of 1 wETH doesn’t fall by more than ~10% — else, it would make sense to just walk away with the loaned USDC.
For example, if at expiry of the loan wETH has increased by ~20%, then it will be rational for the borrower to repay and recoup their collateral. In this case, the lender will earn their desired 12.50% interest.
Now, let’s imagine the same theoretical loan quote, but now this market is moving sideways — there’s been news of Binance FUD (4) and also some quarrels within the ETH Foundation about the state of proto-danksharding. ETH is moving up and down but staying within a range, but slightly shaken by the market conditions.
At expiry of this theoretical loan, the value of the wETH collateral falls to $1700 (85% of the original price). The value of wETH is still above the loan taken ($1600 USDC at 80% LTV) — however, it is not in the borrower’s best interest to repay the loan since the fixed repayment amount of $1800 USDC is worth more than potentially recouping $1700 worth of wETH.
In this scenario, the borrower would default, but the lender would still earn a nice yield (~6.25%) as the value of the defaulted wETH is above the original loan amount ($1700 worth of wETH > $1600 worth of loaned USDC).
Let’s take the same loan quote, but now market conditions are getting even tighter. It’s been revealed that the SEC has gone on an all-out attack on Ethereum and is positioning to get it somehow banned in the United States. ETH holds strong at first, but then begins tanking.
At expiry of this theoretical loan, the value of the wETH collateral falls to $1400 (70% of the original price). Since the value of wETH is now below the value of the loan taken out ($1600 USDC > $1400 wETH), a rational borrower would default on the loan and choose not to repay.
The lender would be left with the defaulted collateral — however, at an 80% LTV, there is a buffer for the downside and the lender is left with a 12.50% loss.
It is clear that the payoff for a lender taking on a ZLL is similar to that of a covered call — as well as a type of financial instrument known as a ‘reverse convertible’, which is usually undertaken when you expect a certain underlying to trade rangebound or to appreciate mildly. Such instruments are available for many equities and derivatives and are a common strategy for securing an attractive, risk-adjusted return. It is also important to note that the max upside is capped for the individual taking on this type of instrument.
Greater yield control with MYSO v2
The beauty of MYSO v2 is that the possible prospective yield that a lender wants to earn is fully up to them! Loan parameters such as the LTV, interest rate, tenor, etc. are fully-customizable, meaning both greater control and higher potential yield for lenders that want to take on extra risk in their loan quotes.
With that being said, it’s important for lenders to properly price their loans such that they don’t take on unnecessary amounts of risk or post quotes that are at extremely unfavorable parameterizations towards either party.
Lending on the MYSO v2 testnet is currently open for 3rd party lenders with programmatic access available and if you’d like to try out and see how powerful the v2 is for lenders, feel free to message the team on Discord!
We are excited to share more about the underlying architecture groundbreaking functionalities of MYSO v2 and are looking forward to the mainnet launch 👀
