Notional Finance: Deep Dive

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

By matthew yuen, Jun Hong, Axel Wong, Evanarp

Introduction to Notional Finance

Previously, we explored the nascent space of un(der)-collateralised lending/borrowing where we dove into RociFi, a protocol that harnesses on-chain data and machine learning to generate credit scores for un(der)-collateralized loans. In that article, we said that “over-collateralized lending arguably goes against the ethos and vision of Decentralised Finance”. Nonetheless, we recognise that certain over-collateralized lending/borrowing protocols have the potential to enhance the DeFi ecosystem instead. Such protocols infuse the better aspects of TradFi with Defi, which ultimately helps speed up mass adoption. In this article, we dive into Notional Finance, an over-collateralized protocol that “facilitates fixed-rate, fixed-term crypto asset lending and borrowing through a novel financial instrument called fCash.”. DeFi protocols, no matter collateralised or un(der)-collateralised, are prone to having variable interest rates. Notional aims to bridge the lack of fixed rate instruments.

The founding team of Notional has both TradFi and crypto experience, with one of the Co-Founders, Teddy Woodward, originally from Barclays Bank as a trader and later on at Ayanda Capital. Notional is backed by reputable names like Spartan Group and Coinbase Ventures. Notional was launched in 2020, and v2 in November 2021. Notional has grown since then, with a TVL of US$52 Million and 1083 cumulative users/accounts created.

Requirement for Fixed Rate Lending

Fixed interest rate protocols in DeFi are similar to traditional financial instruments that offer a fixed return on investment, such as fixed-rate bonds and are designed to provide a stable and predictable return on investment for users. As per the US Treasury Monthly Nov 2022 Statement, of the 23.95T USD of marketable treasury securities, only 2.48% are variable rate notes, while the rest are fixed rate notes, bonds and bills. While we probably will not see a similar split in liquidity flowing to fixed and variable interest rates in DeFi, having these figures can provide a lens to view these protocols with.

There are a few reasons why fixed interest rate protocols can be beneficial in DeFi:

Predictability
Fixed interest rate protocols provide users with a predictable return on their investment, as the interest rate is fixed and does not fluctuate with market conditions. For lenders, this can be particularly useful for those who are looking for a stable and consistent source of income. For borrowers, a fixed cost of capital means that decisions made are more well informed. Better cost visibility, ability to decide between raising capital through debt or equity, etc are important decisions that variable interest rates cannot assist as much in.

Source: https://fiscaldata.treasury.gov/datasets/debt-to-the-penny/debt-to-the-penny

We see total outstanding debt consistently increasing, with a 10y average YoY change of 8%. A consistent increase in outstanding debt points to more debt being issued then retired each year, which proves that even in a high interest rate environment, borrowers would rather lock in costs and assure themselves with visibility.

Risk management:
Fixed interest rate protocols can help to mitigate the risks associated with lending or borrowing funds in DeFi, as they provide a predictable return regardless of market conditions. This can be particularly useful for those who are looking to minimise their exposure to risk.

Simplicity:
Fixed interest rate protocols can be easier to understand and use than other DeFi protocols that have variable interest rates, as they do not require users to constantly monitor market conditions and adjust their investments accordingly.

Furthermore, with increased usage of Notional Finance, the implied yield curve can become instructive to market participants. For example, as of 31 Dec 2022, we see that USDC has a normal yield curve with longer maturities demanding greater rates of return. However, this does not hold true for DAI, ETH, and BTC. DAI, in particular, has a humped yield curve, with medium-term rates being higher than short and longer-term rates. ETH and BTC have an inverted yield curve, with long-term rates being lower than short-term rates. In the case of ETH, this could be due to the Shanghai upgrade slated for Mar 2023. Higher rates for the March maturity indicates that market participants expect ETH POS stakers to unstake-and-sell as soon as possible.

Of course, with more liquidity flowing into Notional Finance, longer maturities can be established to flesh out a truly indicative yield curve.

How Notional Finance works

In Notional, there are key terms to wrap your head around, these are:

• fCash
  fCash are transferable tokens that represent a claim on a positive or negative cash flow at a specific point in the future.
• nTokens
  nTokens are the primary way users provide liquidity to Notional, and are ERC20 assets that are redeemable for a share of Notional’s total liquidity in a given currency across all active maturities.
• cTokens
  cTokens are interest-bearing assets native to the Compound protocol. cTokens are used within Notional to increase returns for liquidity providers.

These tokens form the bedrock on which Notional Finance is built and allows for the following parties to be involved:

• Lenders
• Borrowers
• Liquidity providers
• Liquidators

This following section gives a detailed breakdown of these terms and explains how Notional works.

fCash

fCash tokens is the core instrument responsible for fixed rate borrowing and lending. It is a transferable token that represents a claim on a positive or negative cash flow at a specific point in the future.

They are generated in pairs: assets and liabilities with a net zero sum.

In other words, the lender receives a positive fCash balance upon lending and the borrower receives a negative fCash balance upon borrowing.

Unlike Notional V1, in Notional V2, the fCash denomination currency is distinct from its settlement currency. fCash is denominated in an underlying token like DAI or USDC as fDAI or fUSDC but it is settled in cTokens e.g. cDai or cUSD. Upon maturity of a loan, fDai has to be redeemed for cDai which is then convertible into DAI at the user’s will.

The cToken is a core composability feature that was introduced to optimise and enhance liquidity providers’ capital efficiency. Here’s how:

• Users can deposit cTokens into Notional Liquidity pools, allowing them to accrue the baseline cToken rate on their capital AND the fees earned in the Notional liquidity pool. (Liquidity providers earn fees every time a lender or borrower trades between cToken and fCash.)
• Notional cash balances also passively accrue interest in the underlying crypto assets.

When conducting transactions, Liquidity providers act as the counterparty to all lenders and borrowers. As such, it’s important to understand how liquidity pools work in Notional starting with tenors.

Liquidity pools

A liquidity pool has a maturity date, it holds fCash that corresponds to the maturity date e.g. Dec 1 2021 fDAi and its settlement currency e.g. DAI. Each liquidity pool has a tenor cadence.

Tenors

A tenor refers to the amount of time between the inception of a financial contract, and that contract’s maturity. In Notional V2, Tenor cadence represents the maturities of active liquidity pools in their respective currencies, and are as follows:

• 3 months
• 6 months
• 1 year
• 2 years
• 5 years
• 10 years
• 20 years

The availability of liquidity pools of any currency type for lending and borrowing are determined by governance parameters. As such, some currencies may only have 2 out of 7 tenors available for borrowing and lending.

It is important to note that the length of time until a liquidity pool’s maturity may not match the liquidity pool’s tenor. For example, if the reference time (refers to the time of inception of the financial contract) is March 1st and the current time is March 15th, the three month maturity will still be June 1st even though June 1st is less than three months away from the current time.

Lastly, every quarter, reference time rolls forward three months. This occurs when the current block time surpasses what was the three month maturity. Rolling the reference time forward updates the active maturities and rolls all liquidity pools forward as well. All active liquidity pools become inactive upon a roll and new pools are initialised at the new set of active maturities. This feature also introduces the concept of idiosyncratic fCash.

Idiosyncratic fCash

Idiosyncratic fCash refers to an fCash asset whose maturity does not match any corresponding active liquidity pools which usually happens after a quarterly roll.

For instance, a user who decides to lend cUSDC in a one-year liquidity pool receives fUSDC. At the time of the next quarterly roll, that user’s fUSDC would mature in nine months, the current liquidity pool would reset after the quarterly roll to a new one-year liquidity pool.

This renders user’s nine-month fUSDC idiosyncratic and they will not be able to trade their fUSDC on any liquidity pools for a period of three months until it becomes a six-month fUSDC suitable for trading on the six month liquidity pool.

So far we understand that liquidity pools in Notional are made of different tenors and currencies. Lenders and borrowers engage in transactions with these pools and receive the corresponding fCash assets in return for borrowing or lending crypto assets. Upon maturity, fCash can be redeemed for cTokens and subsequently could be converted into the underlying crypto asset. From a glance, Liquidity providers are seemingly the most important agents in the Notional Ecosystem. But what incentivises them to inject liquidity? Introducing nTokens.

nTokens

nTokens is a new feature introduced in Notional v2 and builds the entire incentive structure for liquidity providers.

nTokens are tokens that represent a share of the total liquidity in all the individual liquidity pools for a given currency. The liquidity provider deposits cTokens into their nToken account, the nToken account then mints fCash tokens and distributes it along with the cToken into the underlying liquidity pools for that currency and holds the liquidity tokens e.g. nDAI that represent the user’s ownership of their deposited liquidity.

nTokens earn returns in three ways:

• Blended Interest rate
  The blended interest rate is the average of the cToken interest rate and the fCash interest rates at different maturities weighted by the nToken accounts holdings of cTokens and fCash at each maturity.
• Liquidity Fees
  Fees earned every time a user borrows or lends. One of the main concerns of liquidity providers is impermanent loss. Fortunately, the nToken’s potential for impermanent loss is small because fCash exchange rates are very stable — for example, three month fCash can only trade between an exchange rate of 1 and 1.04.
• NOTE Incentives
  nToken holders accrue NOTE rewards proportional to their share of the total nTokens in that currency. NOTE is notional’s governance token. At the time of writing, 1 NOTE is worth 0.15 USD.

The section below explains the relationship between borrowing and lending on the fCash interest rate and the blended interest rate, feel free to skip it if this does not concern you.

Return dynamics

As users borrow more, it increases Notional’s fCash interest rates, the nToken account gains fCash and loses cTokens. On the other hand, when end users lend, fCash interest rates fall and the nToken account loses fCash and gains cTokens. The diagram below illustrates this:

Changes in the fCash interest rates will affect the blended interest rate. If you are concerned about the volatility of the blended interest rate as a liquidity provider, you can rest assured that the blended rate will sit somewhere between the cToken supply rate and the fCash interest rates on Notional.

However as blended interest rates rise, the nToken will experience impermanent loss and the value of the nToken will drop. Conversely, when blended interest rates drop, the value of nToken rises.

nToken redemption

nTokens are redeemable for a proportional share of all the assets in the nToken account. Upon redemption, users can elect to receive a single net cToken amount by converting their share of the nToken account’s net fCash positions to cTokens via the on-chain liquidity pools.

More details on the redemption process can be found here.

Now that you’ve understood these key terms, We will move on to understanding how Notional works from the perspectives of the parties involved.

Lender

Lenders buy fCash by exchanging their currency at the time of trade for a larger amount at a specific point in the future determined by the tenor of the liquidity pool in which the transaction was conducted. The right to claim this future amount is represented by fCash.

Here’s an example of the lending process:

It is December 2, 2020. User A decides to lend 100 DAI on Notional for a year.

1. The lender first converts their 100 DAI into cDAI
2. He deposits that cDAI into the Notional liquidity pool for 105 fDAI.

3. When the loan matures on December 1, 2021, the lender can redeem their 105 fDAI for cDAI, and then convert that cDai into 105 DAI.

Borrower

Borrowers have to put up collateral in order to mint fCash and sell it for the specified currency that they need. By doing so, they receive currency in exchange for the obligation to repay a fixed amount of currency at a specific future time.

Here’s an example of the borrowing process:

1. A borrower puts up 1 ETH as collateral in their Notional portfolio

2. This allows the borrower to mint fCash at their chosen maturity e.g. 1 year

3. The borrower can sell the minted fCash token into its liquidity pool for currency which they can withdraw.

4. When the loan reaches or has reached maturity, the borrower can choose to repay the loan or roll the loan forward to the next maturity

Liquidity provider

Liquidity providers have to contribute cTokens and fCash to liquidity pools of a given currency to receive liquidity tokens and liquidity fees.

1. The liquidity provider wants to provide 100 DAI into a pool
2. He mints a pair of positive and negative fDAI tokens through his nToken account
3. He converts his 100 DAI to 100 cDAI
4. He deposits both his cDAI and fDAI into the liquidity pool and receives liquidity tokens representing the proportional share of the pool.
5. The liquidity tokens represent a claim on both fDAI and cDAI and can be redeemed anytime.

Types of Activities & Users

Activities on Notional

Although Notional is primarily an over-collateralized lending/borrowing protocol, lending and/or borrowing are not the only two activities that one can do on Notional.

Other activities include 1) Staking of $NOTE tokens, 2) capitalising on the relatively new Leveraged Vaults, and 3) providing liquidity (to liquidity pools). A brief overview of these 3 activities is outlined below:

1) Staking
Unlike in other protocols, Staking in Notional is somewhat of a misnomer. Although the staked version of $NOTE is $sNOTE, users are actually depositing $NOTE and $WETH into a liquidity pool in a 80/20 ratio in exchange for $sNOTE. Hence, users should be mindful of impermanent loss (although the 80/20 ratio serves to offset this) when they are “staking”, and that they are, in essence, liquidity providers instead.

2)Leveraged Vaults
Leveraged Vaults are a relatively new initiative on Notional. Leverage is typically seen as a way for the user to get much higher yields than they could, by borrowing funds from a protocol and then using those funds to, for example, provide liquidity. However, a lot of strategies that utilise leverage are considered risky and subject the user to very high permanent loss. The volatile nature of the underlying tokens combined with the variable interest rates of such other platforms makes it very risky for the user.

Notional, on the other hand, aims to make leverage a lower-risk, low-volatility activity, and at the same time enabling high rates, through fixed-rate lending/borrowing combined with strategies on partner protocols (like Balancer/Aura) that has relatively stable underlying tokens.

3)LP providing

In Notional, providing liquidity comes in two forms. 1) Providing liquidity to all Notional markets, whereby a user exchanges, for example, $DAI for $nDAI and 2) Depositing equal amounts of $NOTE and one other asset on an external protocol (for instance, Balancer) in order to receive $NOTE tokens.

Users on Notional

At first glance, it appears that Users on Notional are primarily Institutions. This is because such Institutions generally desire stable financing with respect to the various activities that they might carry out in the DeFi space. Such Users, due to the large amount of funds handled, will be more mindful of the risks that variable interest rates in other lending/borrowing protocols carry, and therefore choose to use a fixed-rate protocol like Notional. In contrast, Retail investors generally trade/deal with smaller volumes, and stability in interest rates may not, for example, be as important as having higher yields that they might obtain on other platforms.

However, this is not to say that Retail investors will never prefer fixed-rate financing and therefore not use Notional. In an interview with Coingecko, Teddy Woodward shared that a retail user had a mortgage with a bank in Australia and wanted to use lending/borrowing protocols on DeFi. This user then chose Notional over protocols like Aave or Compound because the rates on these protocols were variable. He then borrowed about 500,000 USDC against his ETH on Notional and paid off his mortgage with the Bank with those funds.

Further, as stated above, Fixed-Rate financing offers stability as a value proposition.

As stated in the Notional Finance Docs, the empirical data (most US Debt is issued at a fixed rate) reflects that most users value certainty and stability in terms of what they earn and owe. Hence, both Retail and Institutional investors can certainly benefit from the value proposition that Notional Finance offers in terms of both lending and borrowing

Competitors Analysis

The most notable difference between Notional Finance and other fixed rate protocols such as Element and Pendle is that Notional Finance offers fixed rates for both borrowers and lenders whereas most protocols only offer fixed rates for lenders due to the difference in their construction. For these other protocols, they store their yield generating token in a vault and split it into the principal token and yield/interest token as opposed to the zero coupon bond (fcash) model.

The construction of Notional serves a larger market- borrowers that wish to borrow at a fixed rate which is also beneficial for the lenders since the interest rate will be higher as a result of the premium on fixed rate borrowing.

The closest competitor to Notional is Yield Protocol which also offers fixed rates to both borrowers and lenders. The parallels also lie in the capital efficiency of both protocols. For Yield, YieldSPaceTV allows the base asset in the liquidity pools to be used in a money market protocol like Aave to earn yield which is similar to the cToken on Notional and its integration with Compound.

Besides Notional being more established with a much higher TVL, the biggest differentiator is their Ntoken that removes the barrier of users having to select the liquidity pool based on maturity which Yield does not offer for its liquidity providers.

Source: https://defillama.com/protocol/yield-protocol

Protocol Revenues

Notional has 2 primary sources of revenue:

• Transaction Fees
  They earn transaction fees each time an end user lends or borrows on the platform. Transaction fees are a long-term source of revenue for Notional. Notional earns a 0.25% fee for each transaction. The fee is prorated by time to maturity — for a 1 year loan, Notional earns 0.25% of the loan amount, for a 6-month loan Notional will earn 0.125%, etc.
• COMP incentives
  Currently, Notional’s transaction fees are held in the protocol’s reserve and the COMP incentives earned are converted into LP tokens to reward sNOTE holders. Notional’s COMP incentive revenue is equal to the protocol’s TVL multiplied by the COMP incentive yield for suppliers on Compound. Comp incentives make up the bulk of Notional’s revenue, yielding $388k of $588k worth of total revenue.

Unfortunately, the incentive revenue that Notional earns is temporary. It is unknown how long the COMP incentives will last.

Token

Liquid Supply Curve (Source: https://messari.io/asset/notional-finance/profile/supply-schedule)

Use cases

$NOTE is the governance token of the protocol, and is also emitted to boost incentives for liquidity providers. $NOTE emissions, i.e. inorganic yields, account for 84%, 97% and 84% of returns for the DAI, ETH and USDC LP Pools. Annually, emission rates for the aforementioned 3 pools are 4.25 million, 2 million and 6 million $NOTE respectively.

The $NOTE chart is similar to other Governance tokens and should be ideally sold into ETH or stablecoins whenever viable. Price action has been bearish on all relevant time frames.

However, holding $NOTE has some utility. $NOTE holders can stake $NOTE (and ETH) into the 80/20 NOTE/WETH Balancer pool, in exchange for $sNOTE. $sNOTE then earns rewards in 3 ways

• Protocol Revenue Reinvestments
• Currently, 0.25% pro-rata fee of any lend or borrow transaction is charged as protocol fees, prorated by length of loan duration.
• Additional Incentives
• Currently, 30 000 $NOTE per week is allocated for $NOTE stakers, amounting to approximately $4300 USD in incentives per week at 30 December 2022 $NOTE prices

Therefore, speculators who wish to bet on the increasing usage of fixed interest rate protocols can do so by staking $NOTE to receive protocol fees generated. This strategy can be further sharpened by taking an equal short position in $NOTE to cancel out underlying price movement, while earning protocol fees. However, the lack of any CEX offering $NOTE perpetuals means this strategy cannot yet be implemented.

$sNOTE can be unstaked only after a 15-day unstaking window, after which users must redeem unstaked $NOTE within a 3-day unstaking period.

Growth Projections

The team at Notional initially identified 2 challenges that would hinder its growth. The first challenge being the clunky user experience for liquidity providers in which they have to manually choose the pool based on maturity. The second challenge being the lack of borrower demand that stifles interest rates and limiting its competitiveness as a protocol. We will now examine how Notional’s new updates and features tackle these challenges.

V2 was introduced in Q3 2021 with a focus on improving the experience and returns for LPs, the pillar of the protocol. The former is achieved through the introduction of nTokens which removes the hassle of choosing the liquidity pool as the whole process is now automated as explained at the start. For the latter, liquidity providers now deposit cTokens into the liquidity pool as a result of Notional’s integration with Compound. Liquidity providers are now able to earn cToken lending rate in addition to interest earned lending out their capital on Notional and liquidity fees occurring to Notional’s liquidity pools.

Leveraged vaults was introduced in Q3 2022 which takes borrowing to a whole new level. In short, users borrow at a fixed rate, deposit into a whitelisted smart contract executing a specific yield strategy with the assets in the smart contract acting as collateral for the loan. This enables the borrower to earn the difference between the strategy returns and notional’s fixed rates.

Ok that was a lot to digest so let us walk through an example.

Leveraged vaults: https://blog.notional.finance/introducing-leveraged-vaults/

1. Borrower brings 100k USDC to Notional and borrows 700k USDC from Notional at 4% fixed interest rates for 3 months
2. The sum of 800k USDC is deposited into a vault

3. Over the 3 month term, the vault earns an average of 8% APY through a yield strategy (Balancer/Aura Boosted Stablecoin LP strategy for this example)

4. After paying off the debt + interest on notional, the users pockets the remaining 109k USDC, a 36% APY over the 3 month term

Leveraged vaults have been successful in driving borrowing demand and have contributed an estimated $3M to outstanding debt.

Looking into 2023, leveraged vaults are projected to have an even larger contribution to the outstanding debt as it moves out of the beta stage and continues to scale partnerships for its yield strategy. The potential high returns using leveraged vaults should accelerate borrowing demand, increasing interest rates and attracting more lenders.

https://defillama.com/protocol/notional

Despite losing most of its TVL over the course of 2022 due to market conditions, Notional V2 proved to be successful in attracting liquidity, with over $900M USD in TVL at its peak.

Notional aims to increase the returns of liquidity providers organically, moving away from its current strategy of using a substantial amount of NOTE incentives. The team plans on deploying a 3 pronged approach for this.

1. Leveraged vaults: increase liquidity pool utilisation and rates at which liquidity providers lend
2. Expansion of base money market integration beyond Compound to earn higher rates on unutilised capital
3. New liquidity curve that improves efficiency and increases LP utilisation

Risks

This section details risks all relevant stakeholders should know.

Insolvency risks

The protocol could become insolvent because some borrowers have become insolvent. If this were to happen, the protocol might not hold enough cash to pay out lenders. They have implemented a robust liquidation protocol and infrastructure that minimises this risk. In the event that a borrower becomes insolvent, they have an on-chain reserve fund to help cover any losses that might arise on the platform.

Security risks

Like any protocol, Notional’s smart contracts might get hacked. They have implemented sufficient internal controls to prevent this from happening and their system has been audited and completed formal certification by the industry leaders such as Certora, ABDK, Code Arena & OpenZeppelin.

Collateral risks

A collateral shortfall is a critical scenario where Notional no longer holds enough collateral to back liabilities for its lenders and liquidity providers.

This could happen due to 2 reasons:

• A Smart contract hack or/and
• Major liquidation failures

Major liquidation failures refer to the risk that the price of collateral assets held on Notional fall dramatically and liquidators are unable to liquidate accounts that have borrowed against that collateral before the accounts become insolvent.

Conclusion

All in all, here we have a protocol that fractionalises liquidity across different time frames, to essentially derive the yield curve that underpins traditional finance.

Compared to the USDC lend rates on bigger money markets like Curve, Aave, Compound (0.21%, 0.47% and 1.10% organic, respectively), lend rates on Notional are much higher, even at shorter maturities. While this does lock in rates for users, this might just be what some types of users want over variable interest rates.

In short, the advantages that Notional has over conventional lending/borrowing protocols are 1) better rates for the borrower/lender, and 2) fixed-rates which offer stability to the user. Furthermore, as stated elsewhere in various interviews with the Co-Founder, Notional’s ability to service both the lender and borrower gives Notional another selling point to onboard more users as compared to other similar protocols that offer fixed-rates as well.

In tumultuous times such as the present, we think that it is not unlikely that users of DeFi would desire stability in their yields and become more risk-averse. Notional Finance then stands out in the arguably saturated lending/borrowing space as a protocol to meet the needs of such users. In the long-term, notwithstanding the benefits of fixed-rate financing as stated above, the gap between TradFi and DeFi can be further narrowed by onboarding more TradFi users as they start to explore how the applications in DeFi can be a viable substitute for the various forms of financing that they are used to. Together with the optimistic note that Notional has ended 2022 with, we are confident that the protocol will continue to grow in 2023 and beyond, making fixed-rate financing more visible, accessible, and attractive, enriching the DeFi ecosystem as a whole.