Introduction to Zero-Liquidation Loans (Part 1)

Zero-liquidation loans bring a new flavor to DeFi crypto borrowing. In contrast to existing borrowing solutions, borrowers don’t face any liquidation risk and are always able to get their crypto back.🤑

So no more need to get all tight when the market gets in your face!

A borrower getting all tight when the market gets in his face.

Let’s look at the most important differences between zero-liquidation loans and conventional DeFi borrowing solutions:🧐

• No liquidation penalties: with zero-liquidation loans you don’t have to worry about liquidation penalties, whatsoever.
• Collateral 100% reclaimable: you can rest assured that you can always get your collateral back.
• No LTV monitoring needed: you don’t need to worry about monitoring your health factor or LTV thresholds.
• Fixed expiry: zero-liquidation loans are fixed-term instruments, whereas other borrowing solutions are typically open-ended.
• No variable borrowing costs: your interest rate costs are known in advance, no suprises with spiking variable rates.

Example of a Zero-Liquidation Loan

Assume you hold 1 ETH worth $4'300 USDC and want to borrow USDC against it for 40 days (e.g., until 31 Dec).

What do you? You head over to myso.finance to take out a zero-liquidation loan! But how would that work out in numbers? Let’s look at a hypothetical example:

1. The platform offers you 2'208 USDC upfront cash at an APR of 12.9%, with an implied LTV of 51%. 😋
2. You decide to give it a try and pledge your 1 ETH to a Myso ETH-USDC-31Dec liquidity pool, receive the 2'208 USDC, and lock in your loan terms. This means that you now have an option to reclaim your 1 ETH for a fixed repayment amount of 2'240 USDC (=13% APR) due on 31 Dec. 🤩
3. After a few days the ETH price suddenly drops to $2'700, implying a new LTV of 81%. 😳 You’re getting nervous because you know that other platforms typically liquidate at these LTV ratios. So you go to myso.finance to check your position, but find that nothing bad has happened. Although the ETH price has dropped, you’re 1 ETH collateral hasn’t been sold, and you still have an option to reclaim it on 31 Dec.😊
4. Then, finally on 31 Dec, the ETH price skyrockets to $5'000. You recall that your zero-liquidation loan is now due and want to reclaim your ETH just in time for New Year’s Eve. You go to myso.finance and see that your loan is now open for you to repay. You transfer the previously agreed 2'240 USDC to the ETH-USDC-31Dec liquidity pool and in return receive back your ETH.😜

Pretty cool, right?

Zero-Liquidation Loan User.

What would have happened in case the ETH price would have stayed down? You still would have been able to reclaim your ETH for 2'208 USDC. But obviously, you would have only exercised your option to reclaim ETH in case the price is above 2'208 USDC because otherwise you could buy it cheaper elsewhere.

How do Zero-Liquidation Loans work?

Zero-liquidation loans are based on options. More specifically, you as a borrower hold a call option to buy an asset (e.g., ETH) at a pre-agreed strike price (e.g., 2'240 USDC) at a future point in time (e.g., 31 Dec).

At the same time, the liquidity pool sells you this optionality, and hence needs to be compensated for this.

In order to determine a fair compensation, the so called “put-call-parity” is used. The put-call-parity is a no-arbitrage condition and tells us that holding an underlying asset (e.g., ETH) is equivalent to holding a portfolio of:

1. a long call option with strike K
2. an amount K in cash, and
3. short a put option with strike K, i.e., S=C_K+(K-P_K).

As a borrower, you want to maintain your upside 🚀in the collateral (i.e., be long a call option) while receiving some upfront cash amount. 💰

In order to make this trade arbitrage free, the cash amount you receive needs to be reduced by the implied put option premium, i.e., K-P_K. So as a borrower, you receive K-P_K but need to pay back K at expiry to get back your collateral. Your APR is therefore K/(K-P_K)-1.

By looking at some actually traded option prices on deribit, one can get a better feeling of how a zero-liquidation loan would play out in numbers in real life.

Example of option prices traded on deribit.

For example, with an ETH price of $4'302, the mid-price of a put option with strike K=$2'240 and 40 days to expiry was $32. The fair upfront cash amount to be paid out through a zero-liquidation loan would therefore have been K-P_K=$2240-$32=$2208. So as a borrower you could sell 1 ETH, receive $2'208 in cash up-front, and have an option to reclaim the 1 ETH for a repayment amount of $2'240. You probably have already recognized that these numbers were in fact the ones shown in the previously described example. 😉

So why not just trade options?

Yes, in theory you could trade the underlying options to replicate a zero-liquidation loan payoff (in fact, this is even desirable to make Myso markets more efficient and arbitrage-free).

However, using zero-liquidation loans instead is different in several important ways and also opens up exciting new opportunities for DeFi:

• Independent of option markets: zero-liquidation loans are independent of existing option markets and can be rolled out even for pairs where no option market currently exists. This is different to other solutions like Ribbon.
• Non-standardized options: zero-liquidation loans come with non-standardized options, i.e., floating strikes. Depending on current borrowing and lending demand, the embedded option strike is dynamically adjusted, leaving it to the market to decide which implied LTVs to be offered instead of being restricted by the strikes of option markets.
• Physical settlement: DeFi options are often-times “cash settled”, and hence not suitable for use cases where a borrower wants to actually reclaim the underlying asset.
• Transactional overhead: replicating a zero-liquidation loan with options creates transactional overhead because a borrower first needs to (i) sell the collateral and subsequently (ii) buy a call option. With zero-liquidation loans, both steps are done in one.
• Use case centric: zero-liquidation loans focus on the borrowing use case. And we believe that borrowers shouldn’t need to know anything about options to take advantage of them. By bringing options into a meaningful and useful context, zero-liquidation loans can drive adoption for option instruments while abstracting away unnecessary complexity for borrowers.
• DeFi first: zero-liquidation loans are DeFi first, and therefore different from option trading done via CeFi platforms, e.g., with regards to accessibility, composability, and risks.

Hasn’t this been done in DeFi before?

There are already some DeFi solutions available that target the same problem zero-liquidation loans do, e.g., Alchemix, Ribbon and Ruler (for a more detailed post regarding Ruler, please see here). So how are zero-liquidation loans different?

Alchemix

• No uncertainty when collateral is reclaimable: with zero-liquidation loans you know when you will be able to get back your collateral. In contrast, with Alchemix borrowers don’t know when the loan will eventually have repaid itself, as this will depend on the effectively realized yield of the corresponding vault.
• No dependency on yield generating vaults: zero-liquidation loans can also be rolled out for collateral currencies where there isn’t any yield generating vault available. This isn’t the case with Alchemix. Moreover, the Alchemix assumes that the underlying yields will remain sufficiently high to eventually pay down the debt.

Ribbon

• No dependency on other option markets: zero-liquidation loans come with their own option market and hence can also be offered for currency pairs, strikes, and expiries where no market exists. In contrast, Ribbon can only offer option strategies in case a corresponding market exists on opyn.
• Physical settlement: zero-liquidation loans are physically settled, meaning that the borrower can actually reclaim the underlying asset. In contrast, conventional DeFi options are typically cash settled (see here)

Myso Finance

If you’re as excited as we are about zero-liquidation loans and want to learn more about us, please visit us on myso.finance.

And please make sure to also join us on twitter, telegram and discord. Hope to see you soon Mysooooors!

Picture of a happy Mysoooooooor. All credits go to PS_M11#3715.