Deep Dive: Gearbox Protocol

Published in

SMUB Research

11 min readJan 10, 2023

Co-authored by: Kai Xuan , Megan Aw & Reuben Yang

Nothing following this constitutes financial advice — if construed otherwise, NGMI.
All data presented henceforth are accurate as of 31 December 2022.

Introduction: Macro Overview

Macroeconomic conditions have remained largely unchanged over the past few quarters. Inflation continues to run rampant above ideal levels, the treasury yield curve remains inverted and Russian-Ukraine war pressures have yet to abate. In such a chaotic economy, hawkish sentiments continue to persist, for good reason, and following the December 14th 50 bps increase in interest rates again, rate hikes are expected to continue well into the next year.

On a more optimistic note, inflationary problems seem to be somewhat relieving — albeit at a rather slow pace. The US inflation rate has steadily slowed for the 5th month in a row, with the latest report of 7.1% falling under the 7.3% expectation. Should this trend continue, we may see funds flowing back into risky assets.

With the major cap coins (BTC and ETH) still being closely correlated to equities and higher-risk assets, the cryptocurrency market has not been able to break out of its slump — further dampened by the credit crisis which saw the collapse of numerous well-known exchanges in mid-November. Such a staggering loss of trust may further delay the return of long-term investors.

It is important to note that a persistent macro downtrend may negatively impact the performance of GEAR and therefore it should be taken into account in the analysis of the project.

Introduction: DeFi Overview

Narrative for DeFi remains unchanged with its immutable transaction capacity provided by blockchain technology, serving as an alternative to traditional finance. The recent collapse of major exchanges has shown that the safest way to store funds would be on-chain, where custodial risk is limited. The influx of funds on-chain serves as a catalyst for growth within the DeFi sector.

Despite the wipeout, the present sentiment leans towards “value” buys, with certain sectors showing signs of strength and continued growth. Therefore, GEAR could prove to be one of the success stories in the current bear market.

Introduction: Leverage/Yield Farming Overview

Yield Farming in Ethereum DeFi is led by several DEX giants: Aave, Curve, Compound and Yearn. All four offer simple token swaps and liquidity provision (“yield farming”) opportunities, with slight differences occurring in the type and incentive of pools offered, as well as leverage abilities. While some composability may occur between projects like Curve and Yearn, or with smaller projects like Convex for Curve, general composability between all four, and with various external projects in the DeFi space, is still rather limited.

Gearbox allows for composability between these major players by abstracting leverage onto a generalised platform. On the one hand, the AllowedList policy restricts users’ choice of assets but, on the other, it also helps minimise the risk that the user has to take on by being selective with the quality and safety of accepted projects. The latter point helps to protect both users and protocol integrity.

Existing Industry Problem

While there are many protocols that allow for leveraged operations presently, most of them are not composable and this serves as a limitation for capital efficiency, as this lack of composability leads to a significant amount of idle assets and underutilised capital. The protocols that do exist to utilise other projects are usually created based on only one or two major players and become fully dependent on that one giant, catering fully to its ecosystem without allowing room for composability with external projects — meaning that composability in general is still weak and limited within the DeFi industry.

Additionally, upcoming protocols which aim to solve this issue usually build their goals on connecting the major players, since that is where the majority of the money flows through — since the greatest interest rates and profit potentials can typically be found on newer, younger platforms with fewer users and funds locked, this can prove to be a significant disadvantage for the adventurous DeFi user.

As a protocol, Gearbox presents a unique solution to the composability problem, with an independent, community-reliant method for expanding its ever increasing composability network.

Protocol Overview: Gearbox Protocol

Gearbox is an on-chain, generalised leverage protocol built on Ethereum. It has two sides to it: passive liquidity providers who earn low-risk APY by providing single-asset liquidity; and borrowers who borrow those assets to trade or farm with up to x10 leverage.

Put simply, Gearbox is similar to a lending protocol like Aave with the main difference being that the funds loaned on Aave go directly to the borrower’s wallet whereas the funds loaned on Gearbox goes to a Credit Account where subsequent operations are subject to predetermined and preapproved parameters. Leverage is achieved by the amount of funds that can be borrowed — multiple times more than the user’s initial funds.

Liquidity Providers

Liquidity providers (“LPs”) play a very typical role in Gearbox’s yield farming ecosystem. Similar to as in any other protocol like Aave or Compound, LPs supply the ecosystem with a single type of asset within an isolated pool, earning APY based on the risk (volatility) of the asset: this asset can then be utilised for borrowing leverage, with the borrow rate being dependent on the pool utilisation.

When supplying capital, LPs receive “Diesel” tokens (“dTokens”), which automatically earn interest based on the individual user’s proportional ownership of the pool. The dTokens constantly accrue value, ensuring that the LP does not have to independently collect the interest on a frequent basis.

Borrowers

Borrowers can take advantage of composable leverage that is made possible by the protocol’s novel DeFi primitive: Credit Accounts.

A Credit Account is an isolated smart contract which holds the user and borrowed funds with predefined parameters such as liquidation thresholds imposed and is non-custodial so users retain ownership of their assets. The user will be able to use the Credit Account to interact with a list of allowed protocols and tokens that are decided by the Gearbox DAO and participate in margin trading/leverage farming and many more.

AllowedList Policy

The AllowedList policy is the underlying principle behind the predefined list of whitelisted smart contracts and tokens that the Credit Accounts can interact with.

Allowed Contracts List

Users can interact through Credit Accounts only with contracts from this list to mitigate risks that funds will be sent to vulnerable smart contracts.

Allowed Tokens List

This allows managing risks of swapping funds to highly-volatile assets whose price could drastically fall after a swap and before a liquidation would take place.
Another attack vector is a user creating some dummy ERC20 token and then buying it on a DEX — essentially draining capital from Gearbox Protocol.

Governance
It is not unusual for initial core members and contributors to hold a larger proportion of tokens than regular investors, which essentially means whale portions dominating governance as voters. Gearbox aims to solve this issue by limiting weights of whales and having a delegation function where small holders can delegate their tokens to community delegators whom they share common ideologies with.

Fig 1.5: Reverse Voting Escrow Mechanism

The reverse voting escrow mechanism works in such a way where the community members including credit account mining and other portions get a multiplier of x1 while initial core members who hold a large portion of the tokens get a reduced multiplier of x0.125, essentially increasing the voices of the community members and reducing the influence of the decisions made by the core members. The weight multiplier can be adjusted to ensure an equilibrium is maintained such that all holders are taken into consideration. This could potentially solve the issue of bribe protocols accumulating governance tokens and controlling the governance systems as seen in many other major protocols.

Liquidation
The protocol ensures over-collateralization while allowing users leveraged operations by having an efficient liquidation mechanism. Liquidations are done by liquidator bots that can be deployed by anybody to secure the protocol.

Criteria for liquidator bots to liquidate your Credit Account is as illustrated below:

Fig 1.6: How liquidation works on Gearbox

Having a Health Factor (”Hf”) slightly above 1 puts you at risk of being liquidated. If your Hf is close to 1, you can:

Add Collateral
Change Strategy
Decrease Debt

Revenue Generation

Liquidation Fees

If a Credit Account is liquidated, some percentage goes to a third-party liquidator who liquidated the account and some percentage goes to Gearbox Protocol
Liquidation fee going to liquidator: 4%
Liquidation fee going to protocol: 1.5%

APY Spread Fee: 50%

The protocol takes the spread between the APY which LPs receive and the fee farmers pay for borrowing as a fee.

All protocol fees go to governance and nothing is assumed for the core contributors or the foundation. The protocol is fully operated by a DAO community.

Network Growth Stats

TVL

Credit Account TVL: 5670% increase over the last 12 months
Liquidity Pools TVL: 969% increase over the last 12 months

Cumulative Users

32231% increase over the last 12 months

Credit Accounts TVL

Ecosystem Fit

Considering how many established protocols within the DeFi industry already allow for leveraged yield farming, Gearbox’s provision of these tools does little to separate it from the crowd, despite small novelties like their credit accounts and reverse voting escrow mechanism. As such, Gearbox’s real value would not be in (likely unsuccessfully) attempting to steal users from major players, but in being a bridge and an enhancer between the major yield farming platforms to allow even more efficient fund usage for the existing DeFi clientele.

Competitive Advantage

Being a category leader, the main draw of Gearbox is its ability to maximise utility of borrower’s funds. Gearbox removes the need for overcollateralized loans and abstracts leverage operations onto a generalised platform. This allows for minimising idle funds and removes the need for linking one’s wallet to multiple dApps — think of it as a one-stop shop for whitelisted assets and protocols where you can utilise various leverage-strategies ranging from simple to sophisticated. On a practical note, streamlining processes in such a way reduces the number of login credentials required by each user.

Scalability

With Gearbox being a pioneer in composable leverage with little to no competitors, it has a first mover advantage in capturing market share. It has a strong network of partnerships and is constantly looking to expand to new projects with V2 integration with Curve Finance, Lido Finance and many more. With the increase in partnerships and integration, Gearbox protocol has potential for exponential growth with the increase in adoption of the protocol.

Flexible Risk Parameters

Unlike Compound and Aave which have the same collateral factor (loan to value) against all debt assets; which could lead to bad debt in case of big liquidation of a short position where it is impossible to buy enough low liquidity token on DEXes without big slippage, Gearbox’s loan to value depends on both borrowing and collateral assets as each pool has separate credit managers and own list of allowed tokens and liquidation thresholds. Leverage factor on correlated assets and stablecoins are higher as they are deemed safer than others. This essentially minimises the risks of the protocol falling into bad debt arising from liquidations which have piled upon the biggest decentralised lending protocols like Aave and Venus.

Strong Community

Despite markets experiencing a downturn and the cryptocurrency market being in a bear market, Gearbox has managed to maintain its total value locked (“TVL”) at a consistent level, signalling strength in this bear market. Moreover, it has recently launched the cider’ed launch which is aimed at creating a liquidity pool for the native GEAR token. The response was remarkable with 3000 Ether locked within 30 minutes to reach the hard cap. This shows the conviction the community has in the protocol as well as the optimistic outlook on the price of GEAR when it goes to market. With such strong support even in the bear market, it signals strong potential for success.

Tokenomics ($GEAR)

The GEAR token is an ERC-20 utility token that is currently a governance token for the protocol. The Gearbox team has mentioned that, if the DAO votes for it, additional tokenomics can be introduced in future. The supply of GEAR is capped at 10,000,000,000 and the token distribution is as pictured below:

GEAR is currently listed on a number of exchanges such as OKX, MEXC, Uniswap V3 and Gate.io. As the token was released slightly over a week prior to the point of writing, there is no data substantive enough for us to work with — that being said, we view holding the GEAR token as a proxy to betting on the protocol at large.

Risks

On risks, the first and most apparent one is third-party risk. The prime concern surrounds Gearbox Protocol’s ability to withstand mass liquidations without having to halt the network. In order to handle such adverse situations, third-party liquidators have to do their job right to liquidate before positions start being exposed to the downside. To help liquidators perform their duties promptly and accurately, computation of the Hf metric has to be done in real-time and such information has to be updated with, ideally, no latency.

A secondary concern would be that in order for the protocol to continue growing, the incentives for liquidity providers have to improve. The current supply APY across the various pools are significantly lower than that outside of Gearbox and that has to change to draw more users to the protocol. One impetus for growth is that the pool yield can, and likely will, increase as demand for composable leverage increases which would in turn incentivize more liquidity into the protocol.

On smart contract risks, we believe that users can interact with the protocol with a peace of mind as both V1 and 2 of Gearbox have been audited multiple times by big names in the smart contract auditing industry such as Consensys Diligence, Sigma Prime and ChainSecurity.

Conclusion

The main draws for Gearbox are: (1) composable leverage can minimise idle funds and improve capital efficiency; and (2) borrowers can interact with multiple whitelisted dApps and tokens through a single platform (both a practical and security boon).

With potential upgrades to the tokenomics of GEAR, and the promise of greater DeFi integrations, Gearbox is well-positioned to take the market by storm when their arms are locked and loaded and hence, we believe that, barring any macro-level or protocol-level black swan events, there is significant upside for Gearbox Protocol and the GEAR token.