Zumer: At the forefront of the NFT & Metaverse economy
Zumer’s unique dual-pool liquidity keeps your Metaverse assets safe from unintended liquidation and segregates the price volatility risk to different risk takers
Design loopholes in liquidity pools that have caused the fall of some NFT-backed lending protocols
As we pointed out in one of our previous articles, there are deficiencies in using the existing DeFi framework to manage NFT-backed lending. We will discuss more details in this article and why the NFT-backed lending would never be able to scale like Compound and AAVE if we continue to operate within the existing DeFi framework.
The most significant problem with some of the current NFT-backed lending protocols is a lack of the concept and implementation of “credit cost” into the pricing model, AKA the default tendency of a particular asset class from a specific group of borrowers. Why? It’s because they are still using the DeFi framework built by AAVE and Compound, which were developed for managing liquid and money-market-like cryptocurrencies. These conclusions come from direct experience, as we know the space very well: Our tech advisor built the first version of AAVE (it was called ETHLend back then).
The current standard interest rate determination mechanism for most collateralized lending DeFi protocols is based on an arbitrary utilization rate curve (liquidity-determined) on top of an arbitrary anchor rate (such as LIBOR). The use of LIBOR itself is not appropriate in the first place. LIBOR is the interbank funding cost for multinational banks but not for general retail investors. An institutional (low) funding cost for retail investors/traders would only encourage more speculative activities, making crypto trading more volatile. This anchor rate should be viewed as an opportunity cost one has to bear when allocating his/her capital and the liability cost when taking out a loan.
We believe there is a better way to decentralize the determination of this anchor rate (funding cost). Second, we want to talk about the credit cost. In the real world, the credit cost is either determined by experience (AKA historical through-the-cycle default tendency of an asset class) or by the credit spreads in the secondary bond market. Banks incorporate credit cost in their pricing model to build a provision reserve to cover potential losses from loan defaults. However, we don’t see any NFT-backed lending protocols that have a mechanism to price this risk. Instead, they price the liquidity risk into the interest rate model by altering the borrowing rate to drive liquidations of collaterals in order to get back the capital for redemption. This works well for liquid cryptocurrencies but not NFTs (as we have seen from what happened to BendDAO’s bank run). The analogy is banks using a stock trading infrastructure to trade hard assets like real estates/properties?!
What could be worse is that a single lending pool might lead to a concentrated liquidation of NFT collaterals due to this utilization-driven interest rate model. As such, a negative spiral would happen to drive the price of collateral down further, chaos erupts, and Panic Liquidation (liquidity squeeze) becomes the name of the game. Some protocols are trying to build a reserve cushion to mitigate the risk, but this is a very centralized mechanism.
The Metaverse DeFi future
The need for a better DeFi system has thus become imminent to face the current volatility issues of the market and to meet the standards of financial security that regulators are looking to enforce on DeFi protocols. Due to the rapid development of the Metaverse, a new DeFi market has opened up that allows the citizens of the virtual realm to get instant loans against their web3 assets, such as blue-chip NFTs. This is where Zumer comes in. Built by financial experts, Zumer takes into account the current and potential future legal requirements, as well as the market outlook and security, to craft the most sustainable and compliant NFT lending platform to date.
The Zumer way
Translating the real-world banking and investment banking model into a decentralized and automated process, Zumer built an immaculate dual-pool liquidity mechanism that provides a more sustainable risk framework to the NFTxDeFi space. Our interest rate model consists of three components: Funding Cost + Credit Cost + Underwriting Spread (loan origination fee = protocol’s income).
For the funding cost, we apply a decentralized and market-driven voting mechanism to allow the protocol token holders to decide what level of rates is acceptable to the stakeholders, including both the lenders and borrowers.
For the credit cost, we reference NFTfi’s current default rate of around 10–12% as the benchmark and divide the NFT projects into 3 risk buckets: low, medium, and high. The credit costs we charged are currently set at 10% (NFTfi’s average), 15% and 20%, respectively. The credit would change over time as we would adjust with more data we collected to derive a sustainable credit cost. This cost Zumer charges would go directly onto a provision pool which is like a buffer to absorb future losses from collateral liquidation. In order to decentralize the provision pool, we’ve invented a new role — Underwriter — who has a higher risk appetite to take on more risk in exchange for potentially higher returns from the loan origination process. This means Underwriters commit their capital in the Zumer system to act as the risk buffer together with the protocol capital.
Therefore, in addition to the regular liquidity pool (the lending pool) at the center stage of the current NFT financialization process, the provision pool with external liquidity providers (the underwriters) would act as a backup fund to solve liquidity issues in the case of a default. The provision pool pours instant liquidity to yield farmers looking to withdraw their assets during the defaulted NFT liquidation process and uses the resulting liquidation funds to refill its gaps. This mechanism avoids the problem of utilization-driven interest rate volatility, which could drive concentrated liquidation of collaterals.
Simply put, this could be imagined as a structured product with a senior and junior tranche. The lending pool is the senior tranche which offers a stable yield with lower risk, while the provision pool is the junior tranche which offers higher yields but, at the same time, bears the risk of liquidation losses.
Underwriters are encouraged to lock their assets for a longer period through the arbitrary gains generated by the liquidation of defaulted NFTs (experiencing a full credit cycle to achieve long-term risk-adjusted gains). The provision pool’s liquidity providers (the Underwriters) are then rewarded for sharing the protocol’s income via liquidity mining.
The provision pool anatomy
The structure of the provision pool is also defined through the reconceptualized decentralized model of the traditional banking system. The pool includes the protocol’s own safety net or reserve as well as the liquidity generated by external provision providers to cover up for bad loans. The capital locked in the provision pool is then used, through an agreed-upon ratio, to decide the loan balance of the protocol. As Zumer aims to be a fully decentralized DeFi protocol that can not rely on external or government aid in the case of a crisis, the protocol has chosen a conservative path for its first operational phase to ensure maximum protection of loan providers limiting the loan balance to the total balance of the provisioning pool. As the trust around the project grows into a mature phase of operation, the loan/provisioning ratio can be increased to meet the demand of the community.
Zumer’s dual-pool model aims to rebuild trust in the DeFi space while paving the way for a solid Metaverse economy through secure and decentralized financial services to the citizens of the new world.
